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Department Discussion Paper
ABGENTIHA ECONOMIC RECOVElY AND GROWlB
TECBHIQUES lOR INCREASING PRIVATE INVESTMENT
(Background Paper 4)
~ December 1987
Latin America and the Caribbean Country Operations Department IV
Discussion Papers are not formal publications of the World Bark They present preliminary and unpolished results of country analysis or research that is circulated to encourage discussion and comment citation and the use of such a paper should take account of its provisional character The middotfindings interpretations and conclusions expressed in this paper are entirely those of the authpr(s) and should not be attributed in any manner
t ~ bull to the World Bank to its affiliated organizations or to members of its Board of Executive Directors or the countries they represent
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GLOSSARY OF ACRONYMS
AACRE Asociacion Argentina de Conshysorcios Naciona1es de Expeshyrimentacion Agricola
bull ADMIRA Asociacion Meta1urgica Argentina
ANA Administracion Naciona1 de Aduanas
BANADE Banco Naciona1 de Desarrollo BCRA Banco Central de 1a Republica
Argentina BONAVI Bonos Naciona1es de Intereses
Variables BONEX Bonos Externos
CEM CEN Corporacion de Empresas
Naciona1es CEPAL Comision Economica para
Latinoamerica CD Certificado de Deposito CGIARCGR
CGT Confederacion General de Trabajo
CKD CONADE Consejo Naciona1 de
Desarrollo CPI CRM Cuenta de Regu1acion Monetaria
DGI Direccion General Impositiva DIF DJAT Dec1aracion Jurada de
Admision Temporaria DJNI Declaracionmiddot Jurada de
Necesidades de Importacion DNPC Direccion Naciona1 de
Promocion Comercial FIEL Fundacion de Investigaciones
Economicas Latinoamericanas FONAVI Fondo Naciona1 de Vivienda FUNDECO Fundacion Economica GATT
bull GOP GDFI
Argentine Association of Regional Experimental Conshysortia
Argentine Metallurgy Association
National Customs Administrashytion
National Development Bank Central Bank of Argentina
variable interest rate bonds
foreign bonds (US dollarshydenominated Government bonds)
Country Economic Memorandum Corporation of National
Enterprises Economic Commission for
Latin America (ECLA) certificate of deposit Consultative Group on Intershy
national Agricultural Research
General Confederation of Workers
completely knocked down National Development
Council consumer price index Monetary Regulation Account
(Interest Equalization Fund)
General Tax Directorate Deposit Insurance Fund temporary admission import
request import permit
National Directorate of Commercial Promotion
Latin American Foundation for Economic Research
National Housing Fund Economic Foundation General Agreement on Tariffs
and Trade gross domestic product gross domestic fixed
investment
IBRD
IDB
IFS
IlCA
IMF INDEC
INPE
INTA
IVA JNC JNG LIBOR MampLT MCBA
NADE
NFS PAN PEA
PRESEX (PEX)
RER REER
SIC
SICE
SIGEP
SITC
SKD SMI
SNESR
TAR VA
VATVNA WPI YPF
Instituto Interamericano de Cooperacion Agricola
Instituto Nacional de Estadistica y Censo
Institute Nacional de Planeamiento Economico
Instituto Nacional de Tecnologia Agropecuaria
Impuesto de Valor Agregado Junta Nacional de Carnes Junta Nacional de Granos
Municipalidad de la Ciudad de Buenos Aires
Nomenclatura Arancelaria de Exportacion
Programa Alimentario Nacional Poblacion Economicamente Activa
Programas Especiales de Exportacion
Secretaria de Industria y Comercio Exterior
Sindicatura General de Empresas Publicas
Servicio Nacional de Economia y Sociologia Rural
Temporary Admission Regime
I
Valores Nacionales Ajustables
Yacimientos Petroliferos Fiscales
International Bank for Reconstruction and Development
Inter-American Development Bank
International Financial Statistics
Inter-American Institute for Agricultural Cooperation
International Monetary Fund National Institute for Statshy
istics and Census National Economic Planning
Institute National Institute for Agrishy
cultural Technology value-added tax National Meat Board National Grain Board London Interbank Offer Rate medium and long term Municipality of the City
of Buenos Aires Customs Classification for
Exports nonfactor services National Food Program economically active
population Special Export Program
real exchange rate real effective exchange
rate Standard Industrial
Classification Secretariat of Industry
and Foreign Trade General Comptroller of
Public Enterprises Standard Industrial
Trade Classification semi-knocked down small and medium-size
industry National Rural Economic
and Sociological Service trade policy value added value-Added tax indexed national bonds wholesale price index state oil company
PREFACE
This is Background Paper 4 of a series of working notes proposed in conjunction with the Economic Recovery and Growth exercise There were many contributors These include the following members of the mission that visited Argentina in April 1986
F Desmond McCarthy (Mission Chief) Constantino Lluch (LaborEm~loyment) Claudio Frischtak (Industry) William Tyler (Trade) Alberto Verme (Consultant - Private Investment) Thomas Boyatt (Consultant - Export Marketing) Javier Gonzalez-Fraga (Consultant - Monetary) Maria Claudia Franco (Research Assistant) Harutaka Hamaguchi (Young Professional)
Papers were also contributed by Professors M Connelly R Dornbusch and L Taylor The principal counterpart in Argentina was Mr A Canitrot Secretary of Economic Coordination Since these are working notes they often reflect intermediate stages of thinking before the final report was published As such they were not subject to rigorous review procedures of the World Bank or the Government of Argentina
I would like to thank Ms Milagros A Divino for preparing the draft and processing the report through to publication
Contents
Page No
I
II
III
Privatization Unit bullbull Innovative Financing Techniques
Debt-Equity Swaps bull
18
32
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
- 2 shy
(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
- 3 shy
Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
- 4 shy
this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
- 6 shy
(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
- 9 shy
probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
GLOSSARY OF ACRONYMS
AACRE Asociacion Argentina de Conshysorcios Naciona1es de Expeshyrimentacion Agricola
bull ADMIRA Asociacion Meta1urgica Argentina
ANA Administracion Naciona1 de Aduanas
BANADE Banco Naciona1 de Desarrollo BCRA Banco Central de 1a Republica
Argentina BONAVI Bonos Naciona1es de Intereses
Variables BONEX Bonos Externos
CEM CEN Corporacion de Empresas
Naciona1es CEPAL Comision Economica para
Latinoamerica CD Certificado de Deposito CGIARCGR
CGT Confederacion General de Trabajo
CKD CONADE Consejo Naciona1 de
Desarrollo CPI CRM Cuenta de Regu1acion Monetaria
DGI Direccion General Impositiva DIF DJAT Dec1aracion Jurada de
Admision Temporaria DJNI Declaracionmiddot Jurada de
Necesidades de Importacion DNPC Direccion Naciona1 de
Promocion Comercial FIEL Fundacion de Investigaciones
Economicas Latinoamericanas FONAVI Fondo Naciona1 de Vivienda FUNDECO Fundacion Economica GATT
bull GOP GDFI
Argentine Association of Regional Experimental Conshysortia
Argentine Metallurgy Association
National Customs Administrashytion
National Development Bank Central Bank of Argentina
variable interest rate bonds
foreign bonds (US dollarshydenominated Government bonds)
Country Economic Memorandum Corporation of National
Enterprises Economic Commission for
Latin America (ECLA) certificate of deposit Consultative Group on Intershy
national Agricultural Research
General Confederation of Workers
completely knocked down National Development
Council consumer price index Monetary Regulation Account
(Interest Equalization Fund)
General Tax Directorate Deposit Insurance Fund temporary admission import
request import permit
National Directorate of Commercial Promotion
Latin American Foundation for Economic Research
National Housing Fund Economic Foundation General Agreement on Tariffs
and Trade gross domestic product gross domestic fixed
investment
IBRD
IDB
IFS
IlCA
IMF INDEC
INPE
INTA
IVA JNC JNG LIBOR MampLT MCBA
NADE
NFS PAN PEA
PRESEX (PEX)
RER REER
SIC
SICE
SIGEP
SITC
SKD SMI
SNESR
TAR VA
VATVNA WPI YPF
Instituto Interamericano de Cooperacion Agricola
Instituto Nacional de Estadistica y Censo
Institute Nacional de Planeamiento Economico
Instituto Nacional de Tecnologia Agropecuaria
Impuesto de Valor Agregado Junta Nacional de Carnes Junta Nacional de Granos
Municipalidad de la Ciudad de Buenos Aires
Nomenclatura Arancelaria de Exportacion
Programa Alimentario Nacional Poblacion Economicamente Activa
Programas Especiales de Exportacion
Secretaria de Industria y Comercio Exterior
Sindicatura General de Empresas Publicas
Servicio Nacional de Economia y Sociologia Rural
Temporary Admission Regime
I
Valores Nacionales Ajustables
Yacimientos Petroliferos Fiscales
International Bank for Reconstruction and Development
Inter-American Development Bank
International Financial Statistics
Inter-American Institute for Agricultural Cooperation
International Monetary Fund National Institute for Statshy
istics and Census National Economic Planning
Institute National Institute for Agrishy
cultural Technology value-added tax National Meat Board National Grain Board London Interbank Offer Rate medium and long term Municipality of the City
of Buenos Aires Customs Classification for
Exports nonfactor services National Food Program economically active
population Special Export Program
real exchange rate real effective exchange
rate Standard Industrial
Classification Secretariat of Industry
and Foreign Trade General Comptroller of
Public Enterprises Standard Industrial
Trade Classification semi-knocked down small and medium-size
industry National Rural Economic
and Sociological Service trade policy value added value-Added tax indexed national bonds wholesale price index state oil company
PREFACE
This is Background Paper 4 of a series of working notes proposed in conjunction with the Economic Recovery and Growth exercise There were many contributors These include the following members of the mission that visited Argentina in April 1986
F Desmond McCarthy (Mission Chief) Constantino Lluch (LaborEm~loyment) Claudio Frischtak (Industry) William Tyler (Trade) Alberto Verme (Consultant - Private Investment) Thomas Boyatt (Consultant - Export Marketing) Javier Gonzalez-Fraga (Consultant - Monetary) Maria Claudia Franco (Research Assistant) Harutaka Hamaguchi (Young Professional)
Papers were also contributed by Professors M Connelly R Dornbusch and L Taylor The principal counterpart in Argentina was Mr A Canitrot Secretary of Economic Coordination Since these are working notes they often reflect intermediate stages of thinking before the final report was published As such they were not subject to rigorous review procedures of the World Bank or the Government of Argentina
I would like to thank Ms Milagros A Divino for preparing the draft and processing the report through to publication
Contents
Page No
I
II
III
Privatization Unit bullbull Innovative Financing Techniques
Debt-Equity Swaps bull
18
32
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
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(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
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Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
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the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
- 9 shy
probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
IBRD
IDB
IFS
IlCA
IMF INDEC
INPE
INTA
IVA JNC JNG LIBOR MampLT MCBA
NADE
NFS PAN PEA
PRESEX (PEX)
RER REER
SIC
SICE
SIGEP
SITC
SKD SMI
SNESR
TAR VA
VATVNA WPI YPF
Instituto Interamericano de Cooperacion Agricola
Instituto Nacional de Estadistica y Censo
Institute Nacional de Planeamiento Economico
Instituto Nacional de Tecnologia Agropecuaria
Impuesto de Valor Agregado Junta Nacional de Carnes Junta Nacional de Granos
Municipalidad de la Ciudad de Buenos Aires
Nomenclatura Arancelaria de Exportacion
Programa Alimentario Nacional Poblacion Economicamente Activa
Programas Especiales de Exportacion
Secretaria de Industria y Comercio Exterior
Sindicatura General de Empresas Publicas
Servicio Nacional de Economia y Sociologia Rural
Temporary Admission Regime
I
Valores Nacionales Ajustables
Yacimientos Petroliferos Fiscales
International Bank for Reconstruction and Development
Inter-American Development Bank
International Financial Statistics
Inter-American Institute for Agricultural Cooperation
International Monetary Fund National Institute for Statshy
istics and Census National Economic Planning
Institute National Institute for Agrishy
cultural Technology value-added tax National Meat Board National Grain Board London Interbank Offer Rate medium and long term Municipality of the City
of Buenos Aires Customs Classification for
Exports nonfactor services National Food Program economically active
population Special Export Program
real exchange rate real effective exchange
rate Standard Industrial
Classification Secretariat of Industry
and Foreign Trade General Comptroller of
Public Enterprises Standard Industrial
Trade Classification semi-knocked down small and medium-size
industry National Rural Economic
and Sociological Service trade policy value added value-Added tax indexed national bonds wholesale price index state oil company
PREFACE
This is Background Paper 4 of a series of working notes proposed in conjunction with the Economic Recovery and Growth exercise There were many contributors These include the following members of the mission that visited Argentina in April 1986
F Desmond McCarthy (Mission Chief) Constantino Lluch (LaborEm~loyment) Claudio Frischtak (Industry) William Tyler (Trade) Alberto Verme (Consultant - Private Investment) Thomas Boyatt (Consultant - Export Marketing) Javier Gonzalez-Fraga (Consultant - Monetary) Maria Claudia Franco (Research Assistant) Harutaka Hamaguchi (Young Professional)
Papers were also contributed by Professors M Connelly R Dornbusch and L Taylor The principal counterpart in Argentina was Mr A Canitrot Secretary of Economic Coordination Since these are working notes they often reflect intermediate stages of thinking before the final report was published As such they were not subject to rigorous review procedures of the World Bank or the Government of Argentina
I would like to thank Ms Milagros A Divino for preparing the draft and processing the report through to publication
Contents
Page No
I
II
III
Privatization Unit bullbull Innovative Financing Techniques
Debt-Equity Swaps bull
18
32
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
- 2 shy
(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
- 3 shy
Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
- 4 shy
this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
- 6 shy
(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
- 9 shy
probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
PREFACE
This is Background Paper 4 of a series of working notes proposed in conjunction with the Economic Recovery and Growth exercise There were many contributors These include the following members of the mission that visited Argentina in April 1986
F Desmond McCarthy (Mission Chief) Constantino Lluch (LaborEm~loyment) Claudio Frischtak (Industry) William Tyler (Trade) Alberto Verme (Consultant - Private Investment) Thomas Boyatt (Consultant - Export Marketing) Javier Gonzalez-Fraga (Consultant - Monetary) Maria Claudia Franco (Research Assistant) Harutaka Hamaguchi (Young Professional)
Papers were also contributed by Professors M Connelly R Dornbusch and L Taylor The principal counterpart in Argentina was Mr A Canitrot Secretary of Economic Coordination Since these are working notes they often reflect intermediate stages of thinking before the final report was published As such they were not subject to rigorous review procedures of the World Bank or the Government of Argentina
I would like to thank Ms Milagros A Divino for preparing the draft and processing the report through to publication
Contents
Page No
I
II
III
Privatization Unit bullbull Innovative Financing Techniques
Debt-Equity Swaps bull
18
32
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
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(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
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Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
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the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Contents
Page No
I
II
III
Privatization Unit bullbull Innovative Financing Techniques
Debt-Equity Swaps bull
18
32
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
- 2 shy
(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
- 3 shy
Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
- 4 shy
this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
- 6 shy
(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
I PRIVATIZATION UNIT
11 The privatization unit has served as the backbone for several
efforts involving the divestiture of state-owned enterprises The unit is
characterized by its autonomy from the management of the state entershy
prises It is charged with the design and implementation of an action
plan and with the sale of the bulk of enterprises to be privatized The
sale of the larger assets is normally conducted by outside advisors such as
investment banks
12 Composition The privatization unit is normally composed of fi shy
nancial analysts and experts in specific industrial sectors (petrochemshy
icals for example) Staff could come from either the public or private
sector~ and should be managed by a person with ultimate decision-making
authority
13 Tasks The major task of the unit would be to design and impleshy
ment an action plan which would focus primarily on the following issues
(a) Objectives Is the aim of divesting state-owned enterprises (i)
to increase the efficiency of the public sector (ii) to reduce
the budget deficit and thereby inflationary expectations
(iii) to attract foreign direct investment or (iv) to convince
the private sector that the Government is willing to reduce the
role of the public sector
- 2 shy
(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
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Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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(b) Timing Which enterprises should be sold first
(c) Restructuring What rehabilitation measures are necessary to
enhance the prospects for the sale and the value of the sale
to the Government
(d) Marketing Strategy Which enterprises should be offered only to
local buyers and which should also be marketed to foreigners
(e) Execution Evaluating enterprises preparing sales brochures and
lists of potential buyers implementing the marketing strategy
and evaluating and negotiating offers
t4 The World Bank staff could york together yith the Government to
set up the unit help unit members devise an action plan and actually
conduct the divestiture of specific enterprises Though the man-hours
involved vary on a per-company basis an approximate budget for staffing
could be derived from the criteria in Table 1
o bull
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Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
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the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
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discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
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Table 1 PRIVATIZATION UNIT - STAFFING YEARLY BUDGET YEARLY SALARIES (US$)
No of Sectoral Financial Total Sector Companies Specialist Analyst Secretary Overhead Costs a
Petrochemicals 9 12000 8000 4000 40 151200 Steel 1 12000 8000 4000 40 33600
Total 10 184800
a Assumptions Each team is composed of one sectoral specialist one financial analyst and one secretary
- A team could work on as many as two companies at any given time
- The divestiture process for each company takes 12 months
A The Role of Outsiders
15 Privatization programs require diverse and specialized discishy
plines Depending on the objectives of the program the sophistication of
the market and the structure of the sectors to be privatized it may be
advisable to contract the services of various specialty firms Because the
price investors will pay for any enterprise normally depends on the
accuracy of available information ensuring the quality of information
therefore becomes a top priority To this end firms with specialty backshy
grounds in the preparation of information in the appraisal of assets in
the design of sectoral strategic studies and in the execution of divestishy
ture programs might be looked upon as providers of needed services
bull
(a) Auditors The supply of accurate and updated financial informashy
tion is a key requirementin any type of divestiture process To
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
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the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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this end managers of the divestiture should seriously consider
bringing in an outside accounting firm to audit historical and
current financial performance 3imilarly in cases where
financial restructuring is being considered outside accounting
firms would be best qualified to perform the task If attracting
foreign investors is an objective financial statements endorsed
by one of the big eight accounting firms are a priority
(b) Technical Advisors Obtaining a thorough understanding of the
real value of a company requires various valuation methodologies
Among these replacement cost and liquidation value are
parameters that only experts in the specific field would be able
to provide Thus the involvement of technical appraisal firms
should also be considered
(c) Management Consultants strategic reports on the sectors to be
privatized ahould be developed by management consulting firms
The reports should identifY entry barriers in government-conshy
trolled sectors so policies can be designed to encourage private bull
investment The scope of these measures may involve but is not
limited to specific pricing recommendations labor and manageshy
ment issues and so on~
(d) Investment Banks Investment banks can serve as financial advisors to the Government and privatization units in the sale of
11 A major study of the petrochemicals sector was conducted in June 1984 by the Argentine Petrochemical Institute with the sponsorship of the Office of the President and the Secretary of Planning This study could certainly serve as the basis for a more up-to-date strategy paper on that sector
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
bull bull
- 5 shy
the smaller enterprises and as financial intermediaries for the
sale of larger enterprises The investment banks could provide
the technical assistance normally associdted with the sale
merger and acquisition of companies and would define and execute
marketing strategies tailored to the specific characteristics of
each enterprise
(e) Legal Advisors Lawyers can resolve numerous issues prior to the
sale such as labor contracts and contingent and hidden
liabilities They can also execute the actual disposal of assets
to a new owner
B Divestitures The Process
16 Ground Work The first stage of a divestiture process involves
data gathering and analysis The objective at this stage is to probe the
reliability and availability of relevant information and also to gain a
thorough understanding of the business Issues such as types and pricing
of main products market structure suppliers channels of distribution
and labor relations should all be thoroughly examined with a view to
detecting factors that may complicate the sale (eg labor disputes or
intercompany transactions) Unless one has already been completed a
financial audit may also be required at this stage
bull f bull t Restructuring To make the enterprise more attractive to potenshy
tial buyers and maximize the value of the sale to the shareholders cershy
tain rehabilitation measures should be closely examined prior to the sale
These measures may cover a wide range of issues of which the most
noteworthy
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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(a) Labor In cases where enterprises have excessively large labor
forces rehabilitation measures could include early retirement
programs renegotiation of vucracts reallocation of personnel
layoffs or temporary emJ1I~Jltatlt The merits of each must be
examined in the context of Argentinas labor situation Addishy
tionally if the law so allows buyers could be offered the
option of presenting bids based on assets rather than shares
labor force and could negotiate a new contract with the unions
(b) Financial In cases where enterprises show a negative net worth
excessive debt to equity ratios overly costly financial
liabilities non-performing assets investments in non-related
activities and so on the seller can amend these features
through the restructuring of financial statements For example
in a recent divestiture in Colombia a company with a 91 debt to
equity ratio and other drawbacks was converted through accounting
adjustments into a~more attractive 31 leveraged entity The
best offer yielded a price that exceeded book value by a factor
of 10
(c) Production Enterprises operating in different segments of the
same industry (eg aluminum smelter and rolling mill) might be
offered aa a joint package Another recent case in Colombia
involved the separate sales of a palm oil plantation and a palmI
t bullbull bull bull
oil refinery simply on the basis of value-maximization criteria
Similarly in Spain marketing companies in the sherry sector were grouped according to their level of profitability--a profitable
- 7 shy
entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
- 8 shy
discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
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entity was grouped with a less profitable entity to reduce the
chances of getting no bids for the latter Other adjustments may
require eliminating production processes or replacing and
upgrading equipment
(d) Legal If the ownership structure of certain entities is too
complex to appear attractive to potential buyers a legal
redefinition of the companys ownership may be required For
trust as a mechanism for simplifying the transfer of state-owned
enterprises to the private sector The trust obtains funds from
the United States Agency for International Development and uses
these resources to acquire 100 percent ownership of government
enterprises The trust then sells these enterprises to the
private sector as the sole proprietor of the shares which
simplifies the legal requirements of the transfer
18 Valuation Experience dictates that there is no acceptable
simple way to measure the value of an enterprise nor is there a single
value that predicts beforehand what the market is willing to pay It is
therefore suggested that various valuation methodologies be used with a
view to deriving not one but a range of values The following are the
most commonly used methodologies
(a) Discounted Cash Flow (DCF) If the eqterprise is going to be bull t
sold as an ongoing concern the DCF method tends to approximate
the market value The outcome of the DCF method is normally a
range of values derived using various assumptions for the
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discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
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the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
bull
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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discount rate and the terminal value (the factor by which the
last years earnings are multiplied) In countries such as
Argentina where inflation rates are high attention Ilhould De
focused on the short-term horizon as long-term earnings tenJ ~o
have only a marginal impact on the present value of an entershy
prise Financial projections are normally derived by the
management of the enterprise
(b) Comparable Transactions In order to get an initial idea of a
realistic price for a given enterprise it is important to check
recently executed transactions in the same or comparable
industry In the specialty chemicals industry for instance
there were 56 transactions in the United States during the period
1977-1985 Using a range of multiples of book values derived
from these transactions the average value paid in the US for a
company the size of Petroquimica Mosconi was US$584 million (see
Attachment 1) Naturally this value would need to be adjusted to
account for specific country considerations
(c) Replacement Cost Another indicator of value is the cost of
replacing fixed assets but it is often misleading to assume that
the market would be willing to pay a price based on what it would
cost to rebuild a given factory The general tendency is to
correlate an enterprises yalue with its potential for cash ~ bull t bull
generation As a Spanish Government official said in response to
accusations that Rumasas assets were underpriced If one were
to base price on replacement cost all these companies would
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probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
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(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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- 9 shy
probably be worth billions of dollars since the processes and
skills required to rebuild them are no longer in existence
Book ampnd liquidation value are two other assessments commonly used in
evaluating companies
19 Marketing Marketing strategies vary gre~tly Four different
country strategies are summarized in Table 2 The marketing process
Table 2 MARKETING STRATEGY
Strategy Characteristics Example
Integrated domestic international equity offering
Integrated domestic international direct sale
Domestic equity offering
Domestic direct sale
-Industrial economy -Large and highly liquid local equity market
-High growth sector -Profitable company
-Small size of local equity market
-Loss-making condition of companies
-Relatively large size of local equity market
-Size of issue
-Scope of business -Large size of local market -Expressed interest of local investors
British Telecom
Rumasa
Mexicos reprivatization of corporate holdings of the banking sector
Canada-Northern Transportation Corporation Limited
normally encompasses the following functions
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 10 shy
(a) Preparing Sales Brochure The main vehicle for informing the
market about the merits of an investment opportunity is the sales
brochure The brochure sh~uld contain general information on the
enterprises history labor force and financial statements
as well as specific industry information The quality of
information contained in the brochure is critical in shaping
potential investors perceptions about the enterprises value
(b) Preparing List of Potential Buyers A list of potential buyers
would normally include the obvious local market competitors plus
other local firms with an expressed interest in diversification
If the international market is also considered multinationals
with direct affiliation to the enterprises specific industrial
sector or with operations in Argentina should also be on the
list Table 3 presents a sample list of potential buyers for
Petroquimica Mosconi
(c) Defining Marketing Strategy In devising an appropriate
marketing strategy it is important to bear in mind the
particular limitations imposed by Argentinas economy its local
capital markets and the financial condition of the enterprises
targeted for sale Broadly speaking there are four general
types of strategies that can be applied depending on the
situation of the country making the sale These are as follows
bull
(i) Integrat~d DomesticInternational Equity Offering
This type of strategy was employed by the Government of
COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
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rt 01
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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COIIDany
1 elaneseCorp
2 PPG Industries
3) Nattonal Dtsttllers ampChemtcal Corp
4) Do Chemtca 1
5 ~tsut and Co
6 Koppers Co Inc
7) 01 tn Corp
8) Pennzotl
) Atlanttc Rchfteld
10) WR Grace and Co
11) Hercules
12 Unton Carbtde
11) Honsanto Co
SJ41jll
Table 3
Iota) Assets
1783HH
1853HH
12388HH
25617HH
1177HH
1602HH
3224HH
21842HH
5685HH
2543HH
IO127HH
9941HH
Sample List of Potential Buyers for Pmoguillliea HoSlUtconl__
(US ~ Hi11ion)
DescrtDtton or Busnss
Hanufactures and sells a diverstfied ltne of chemicals ftbers and specialty productsHajor orld producer of these items
Engaged n three bustnesses 1) Hanufacture of fiberglass and flat glass 2 Produces protective and decorative finishes for autos
Produces and markets petrochemicals dtsttlled sptrtts and imported nes
Engaged n the manufacture and sales of chemtcals plasttc matertals agricultural and consumer products and other specialtzed products
Worldtde tradtng of commodlttes Acts on orders from tts customers or developed through tts on sales netork Involved in shtpping ftnancing and also n developmentand procurement of natural resources petrochemtcal grains and lumber
Engaged tn productng and marketing specialty chemtcals and plastics for set productsroad matertals engtneered metal products
Hanufactures chemtcals such as urethane organtc and agrtcultural ch~micals Hetal proshyducts as ell
Enaged in otl and gas exploratton and product ton proceSsing refining and markettng of oil and gas and reftned products
Engaged tn oil and gas exploration development reftning and transportation of petroleum ltqutds and natural gas as ell as mtntng (also in manufacturing and marketingpetrochemical products such as aromattcs olefins oxygenated intermedlals and polymers
Hanufactures and sells chemicals Suppltes servtces and equipment to petroleummiddot industry as ell as exploring for otl gas and coal Diversifted
Hanufactures and sells chemtcals and all ted products includlng organicS plasticsater soluble products explostves etc
Engaged in reseirch development manufacture and sale of chemIcals and plastics industrlal gases and related products metals and carbons and SPcCially products
industrial chemicals including detergent and specialty chemiclls polymer products including plast iCs resin products and chemicals and instrumenb Ocvclops eleclromc process controls
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
bull
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
Company
14) GenCorp
(altas General Tire amp Rubber Co)
15) Wltco (formerly Wttco Chemcal Corp)
Hi) Tenneco
7) Cabot
18) Atr Products amp Chemical Inc
19) OCCidental Petroleum
bull 20) Diamond Shamrock
Table 3
Total Assets
1984HH
783HH
20282HH
1629HH
2687HH
12 417HH
4556HH
Sample list of Potental Buyers for Petroauimica Hosconi
(US $HilHon)
OescrlDtton of Business
Diversified company manufacturing passenger and truck tires chemlt~ls plastics and industrtal products for auto construction appliance and defe~se products amongothers
Hanufactures and markets specialty chemicals polymers and petr~chemcals
Processes refines and markets oil and refined petroleum products Manufactures and sells organtc and inorganic chemical products construction and farm equpment Engaged I)
also in the financial service industry
Operates in the field of energy engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica Diversified concern
Engaged primarily tn supplying tndustrlal gases Industrial processes and other equipment and related engineering services chemical products and construction
Engaged in exploring developing and producing natural resources Includtng oil gas and coal Refines petroleum and petroleum products Manufactures fertilizers and other agricultural products and manufactures and distributes industrial chemicals plasticsand metal finiShing products
Exploration for and development of various natural resources Also refining and sellingcommodity and specialty chemicals
- 13 shy
the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
- 14 shy
(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
- 15 shy
and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
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bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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the United Kingdom in its sale of 51 percent of its
holdings in British Telecom A public offering of
shares in an amount equal to Pounds Sterling 05
billion was made simultaneously in the UK US Swiss
Canadian and Japanese equity markets The unpreceshy
dented size of the issue and the ability of the UK
Government to pursue a market-oriented internationally
integrated approach was duemiddot to the industrialized
nature of the UK economy the size development and
liquidity of the UK equity market the profitability of
British Telecom as a company and the attractiveness of
the telecommunications sector to domestic and foreign
investors
(ii) Integrated DomesticInternational Direct Sale This
type of strategy was employed by the Government of
Spain in its reprivatization of the holdings of the
Rumasa Group Rather than selling shares of the major
companies in the Spanish or international equity
markets the Government engaged in the direct sale of
the various companies to both Spanish and foreign
investors The reasons for taking this approach
instead of a public offering were the relatively small
size of the local equity market and the fact that many
f
of the companies in the Rumasa Group operated at a
loss
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
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114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
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perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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(iii) Domestic Equity Offering This approach was pursued by
the Mexican Government in the reprivatization of
coporate holdings that were taken ovr as ~rt ~i the
nationalization of private banks in the fall =f 1982
Given the foreign exchange crisis that has recently
affected Mexico and the countrys continued limited
access to international capital markets the most
appropriate approach for the reprivatization of these
companies was a sale through the local equity market
This market is reasonably well developed and local
investors were able to absorb a reissuance of shares
(iv) Domestic Direct Sale The Government of Canada took
this approach in the privatization of its holdings of
Northern Transportation Corporation Limited Due to
the enterprises quasi-public service character and its
regional market it was determined that neither a
public share offering nor an international sale would
be appropriate Instead the Canadian Ministry of
Transportation conducted a public coast-to-coast
direct marketing effort that resulted in the successful
sale of 100 percent of the equity of the company to a
group of Canadian investors
t bull(d) Executing Marketing Program Implementing the marketing program-
is usually the most time-consuming task in a privatization efshy
fort and it often involves not only distributing sales brochures
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
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114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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and coordinating visits to facilities by potential buyers but
also personal visits to potential buyers the establishment of
data rooms for the distribution of customized information and so
on
110 Evaluation of Offers and Negotiations Depending on the specific
objectives of the privatization program~ both quantitative and qualitative
criteria can be used to evaluate offers The quantitative criteria are noshy
rmally summarized by the net value derived for the shareholders which is
comprised of the down payment the deferred payment the total amount of
debt absorbed by the buyer and the subsidies that result from debt
rescheduling proposals or new credits The qualitative criteria include
a wide range of issues that may divert the final decision from purely
financial considerations creditworthiness management know-how mainteshy
nance of employment infusion of new capital commitment to staying in
Argentina or to not disposing of assets within a pre-determined period and
so on The Governments preference regarding these criteria should be deshy
fined beforehand and made clear to potential buyers
111 Fairness Statement Once an offer is accepted a formal stateshy
ment is normally issued to justify the validity of the process and the
appropriateness of the selected offer This statement is common practice
in divestiture procedures and among other things it helps protect the
seller from potential criticism t
112 Closing Once an ffer has been accepted the official transfer
of assets is executed This procedure regarded as the closing period reshy
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quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
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114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
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perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
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cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
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- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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- 16 shy
quires the participation of lawyers and accountants The lawyers for both
the seller and the buyer draft and execute the transfer-of-ownership conshy
tract An accounting firm is normally selected by mutual agreement between
buyer and seller to conduct a final financial audit of the enterprise The
ultimate sale price will be based on the results of this final audit
113 Table 4 shows a b~eakdown of the various stages involved in dishy
vestitures including time and skills estimates
Table DIVESTITURES THE PROCESS
Stages Time Skills
1 Ground work 1-3 months -Auditors -Investment banks
2 Restructuring 1-3 months~ -Auditors -Investment banks -Lawyers
3 Valuation -Discounted cash flow 1 month -Company management -Replacement cost -Technical appraisal firm -Book value -Investment banks -Liquidation value -Comparable acquisitions
4 Marketing -Preparing sales brochure 1-3 months -Investment banks -Preparing list of
potential buyers -Defining marketing strategy -Executing marketing strategy
5 Evaluation of offers 1 month -Investment banks and negotiations
6 Fairness statement -Investment banks
7 Closing 1-6 months -Lawzers
af Stages 1 and 2 could overlap Note The duratidn of the entire process could range from 6 to 17 months
bull bullbull
- 17 shy
114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
- 18 shy
II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
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- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
- 21 shy
Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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114 In summary a standard divestiture process consists of seven
distinct stages The length of the process and the value received for the
enterprise depend greatly on tllt efficiency and skill with which the
process is handled
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
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perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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II INNOVATIVE FINANCING TECHNIQUES
21 This secticr- fiscusses a number of possibilities for improving
Argentinas capital base A general discussion of some current ideas is
followed by more details on two specific options a housing fund and a
country fund The housing fund emphasizes domestic resource mobilization
while the country fund would be largely financed by external capital In
between there are several other possibilities
A General Background
22 A 1985 study by Bergsten et al~ discusses various policy
alternatives for bank lending to developing countries The study considers
the implications of a Mexico-type package and also considers extending
current instruments to include various cofinancing insurance and
guarantee arrangements It then suggests a number of new instruments to
facilitate repayment either by variants on interest rate changes or
repayment schedules to allow for intra-country economic variations
Another 1985 study by Lessard and Williamson3 takes a longer-term
2 Bergsten CF Cline WR and Williamson J Bank Lending to Developing Countries The Policy Alternatives Institute for Interna~ionalEconomics ashin~on DC April 1985
t bull I
Lessard DR and Williamson J Financial Intermediation Debt Crisis Institute for International conom~cs
September 1985 bull
bull lt ~ bull ~
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perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
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III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 19 shy
perspective and analyzes an array of financial instruments that could help
facilitate capital flows These include an increased role for nonbank
financial institutions in equity investment and in project investment wlth
returns determined to some extent by physical output or profit sharing
This type of project financing has actually been done in Argentina The
actual financing package engineered for Yacyreta and Central-Oeste gas
pipelines are summarized in Table 5 At this juncture it seems desirable
to minimize the financial contribution of the public sector where
possible Product or output sharing also seem to be desirable ways to
spread the risk This could for instance involve tying returns to an
international price for the project output
23 The shortage of development finance has resulted in an upsurge of
alternate ways of providing economic services A recent study by Wellons
et a14 analyzes various institutional arrangements for accommodating the-
required financial intermediation This study gives policy recommendations
for host governments on topics such as how to encourage foreign investment
without forfeiting controls One of the vehicles the authors discuss is
leasing a practice that has not grown as rapidly in Argentina in recent
years as it has in other countries Levack5 estimates for example that
Italy may have as many as 2000 leasing companies The advantage to
lessees in manufacturing or construction is that they reduce the need for
capital loans they might not be able to get for security reasons or because
of limited access to the necessarr foreign exchange For operators like
Wellons Po Germidis Do Glavanis B Banks and Specialized Financial Intermediaries in Development OECD Paris 1986
Levack I Financial Leasing in Brazil and Italy Middle East Business and Banking March 1986 Vol 5 pp 13-22
- 20 shy
these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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these leasing is an off-balance sheet operation The lessor benefits br
including a mark-up for his package and has title and recourse to the
items financed In short leasing channels finallcial bbviulSo into producshy
tive investment For Argentina the concept could concu middotby be extended
to make the Government the lessee This would in effect be a forward-lookshy
ing debt-equity saving yielding new capital rather than a financial reshy
ordering of existing stock
Housing Fund
24 In most countries one of the major components of real demand and
real investment is housing In early 1987 housing activity in Argentina
was at a low ebb for a variety of reasons including lack of adequate
financing at appropriate rates and the fear that rent control measures
would be introduced Housing activity--which could be a major vehicle for
reactivating the economy--did not appear to be functioning very well
25 Ironically there are major flows of funds to two of the institushy
tiona involved the Banco Hipotecario and FONAVI The Banco Hipotecario
is a major recipient (over A 1 billion) of rediscounts while FONAVI beneshy
fits from earmarked wage taxes estimated at around A 500 million per year
The failure to better utilize such large amounts of scarce reeources
warrants close examination It is expected that financial sector reform
will address the rediscount issue while a housing sector study will proshy (
vide more insight into the sector as a whole~
~ A December 1986 IBRD Social Sector Review Mission also provides further analysis of the sector
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
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have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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Table 5 lYPICAL PROJECT STYLE FINANCING
Project Description
Project Sponsors
Project Location
Project Vehicle
Total Debt Financing
ImportExport Credit and Other Debt Sources
Bank Loan Component
Type of Loan
Amount
Maturity
Recourse after Completion
ll1slts Assumed by lanka
Lenders
Lead Banks
ugust 15 1986
Cogas co 51
Gas pipeline project
Nascap BV (Netherlands) 700 Tecasa S (Argentina) 205 Pamar 5 (Argentina)
Argentina
Corporation
$875000000 (equivalent)
Dfls 1100000000 of Dutch export credit facilities $100000000 of Dutch export credit facUities
Syndicated lac
$85000000 syndicated term loan $65000000 short term loan $75000000 standby facility
Up to 7 years
Limited recourse to Argentine Republic non-recourse to contractors
-COmpletion middotUninsurable orce Majeure middotPolitical risk
Amsterdam-Rotterdam Bank (Agent) Lloyd Bank International
bull I
Entidad Binacional Yacyreta
Hydroelectric project
Argentine Republic Republic of Paraguay
500 500
ArgentinaParaguay
Binational entity
$2176000000
$826700000 of export credits $708500000 World Bank direct loan and co-financing $420000000 lADB direct loan and complementary financing Y5OOOOOOOOO Japanee private placement
Syndicated loan
S200OOOOOO
12 Years
Argentine Republic guarantee
Horgan Guaranty (Agene) Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland
- 22 shy
26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
bull
bull bull
bull
bull bull
Attachment 1 Page 2 of 6-43shy
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
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Attachment 3
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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26 In the meantime some of the more successful approaches to housshy
ing finance warrant consideration In the-early 1970s Colombias housing
sector faced problems similar tv those faced by Argentina today In partishy
cular housing finance was inadequate and poorly managed Colombia
reversed this pattern however and housing ultimately became a leading
sector in the economy of the 1970s A key reason for this reversal was the
creation of a viable system for saving and housing UPAc71
UPAC
27 Before UPAC was founded in 1972 housing finance was heavily
subsidized by public funds Housing activity was virtually stagnant that
year but the originators of UPAC saw the potential for creating
substantial employment with only minimal demands on foreign exchange
28 A key feature in UPACs success was the way that inflation was
handled for mortgage payments Interest rates were kept constant while
the principal was adjusted for the cost of living ensuring that mortgage
payments bore an essentially constant relation to income This arrangement
also protected savers against erosion by inflation The net effect was
that the speculative effect was minimized and operating margins were
reduced From UPACs meager beginnings in 1972 savings grew to US$3
billion by 1985 and the number of depositors went from 60000 to 35
million Despite inevitable criticisms the consensus is that the system has provided greater protection to savers financed a substantial increase
II This is described at a popular level in UPAC A Theory Converted into a Successful Reality Currie L Rosas LE Instituto Colombiano de Ahorro y Vivienda Bogota 1986 A more technical description is given by Gomez CAZ La Correccion Monetaria y el Credito en UPAC Bogota 1986
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in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
- 23 shy
in housing and enabled housing to serve as a leading sector in the
reactivation of the economy
Country Funds
29 Country funds are similar to mutual funds investors buy units or
shares in the fund and they enjoy the capital appreciation and dividends
(if any) derived from it Country funds are usually structured as investshy
ment companies that use investors money to invest in equity securities in
the country of origin A professional investment manager is usually hired
to manage the proceeds for the investors
210 The investment company created could be either open-end or
closed-end In the case of an open-end investment company the units or
shares are redeemable at any time at the net asset value of the shares in
the fund The fund could also issue new units at any time to interested
investors Closed-end investment companies do not offer the investor the
right of redemption and are limited in their ability to issue new units or
shares
211 The establishment of a venture capital fund for Argentina could
be a useful scheme for attracting foreign investment into the country
Among the advantages of the country fund for both investors and local authshy
orities are that the fund bull I
(a) Is the most effective method of raising equity capital from
international securities markets Until international investors
- 24 shy
become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
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become familiar with a countrys securities market alternative
equity securities such as shares or convertible bonds issued by
cwp~=i~s in these countries would be extremely difficult to sell
into~ationally
(b) Facilitates control of foreign investment If a market is opened
directly to foreign portfoliO investment it becomes difficult to
monitor and regulate the direction and frequency of capital flows
into and out of the market When an investment fund channels the
foreign investment the Government has more control over the
investment flows into the country
(c) Diversifies risk By offering a basket of equity securities the
risks of individual securities are reduced
(d) Brings the local market to the international market
Institutions are often hesitant to invest in the local market
directly and then are more likely to invest through the purchase
of shares or units of the country fund Furthermore the country
fund shares are more liquid and easily tradeable in the secondary
market
(e) Eliminates speculative flows that could have disruptive effects
on the local market and on the external value of the currencybull bull I
The control aspect of the country fund is all the more critical
in todays uncertain international environment where speculative
investment has become widespread among even the largest
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institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
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have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
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Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
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III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
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Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
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36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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bull
- 25 shy
institutional investors The investment fund not only permits
overall regulation of foreign equity investment but can also
incorporate a feature whereby investors are unable to wlthdraw
their investment for a period of up to two years froIl che date on
which the investment was made The funds for Brazil South
Korea and Taiwan all provide this initial lock-up feature
(f) Offers expert management for investors who are unfamiliar with
the market Country fund management companies are often jointly
owned by international institutions specializing in fund manageshy
ment and by institutions of the country concerned Together they
provide the investor with expert management adapted to the envishy
ronment of the particular countrys market which the individual
foreign investor would be unable to provide himself
212 As a result of the advantages of the investment fund structure
and its effectiveness in raising equity capital from the international
securities market a number of newly industrialized countries--including
Brazil South Korea and Taiwan--continue to restrict foreign security
investment exclusively channelling foreign capital into their respective
country funds
In the Argentine case one of the primary considerations would be
to test the market by surveying institutional investors about the idea of investing in Argentine securities Mexico which has debt problems similar
to Argentinas set up a country fund that declined 77 in market value
since its establishment in 1981
- 26 shy
B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
- 27 shy
the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
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B Purpose of the Argentine Fund
214 The proceeds from the fund could be usee tc ~~vest in either
equi~ securities traded in the local market in a ~nket of projects or
in a combination of both Since Argentinas stock market has a total
market capitalization equal to US$16 billion (end of 1986) and average
daily trading volume equal to US$318 million a combination of equity
securities and projects should be considered more seriously Even though
the returns on government securities would be higher the fund should not
invest in debt securities since the purpose of the funds is to attract
foreign investment in equity interest If the funds were invested in debt
instruments the result would be equivalent to a bond offering to subsidize
Argentinas debt and virtually no foreign investment would have been
achieved
215 Equity capital is the preferable form of capital for the current
stage of Argentinas economic development It provides a stable base for
the financing of projects in all sectors--commercial industrial financial
and natural resource--and eliminates the burden of both fixed interest and
principal payment schedules on this foreign risk The new vehicle would be
particularly attractive in light of Argentinas severely limited sources of
foreign investment
C Procedures to Establish a Country Fund
216 The procedures to establish a country fund vary depending on
whether the country prefers to issue the securities to the public (as in
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
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have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
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Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
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III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
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Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
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36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
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dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
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cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
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Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
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316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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the Korea Italy and France funds among others) or whether it wishes to
privately place the units or shares with institutional investors
(Brasilvest) In this particular case the US equity market will be
selected since it is the largest deepest and most resilient equity market
in the world
217 In order to establish a country fund in the US a closed-end
investment company would be formed under the Investment Company Act of
1940 Usually the investment company is incorporated in a state with
lenient tax regulations such as Delaware The type of investment company
is usually closed-end since a fund of this type should have a steady
equity capital base in order to realize long-term capital gains
218 Once the closed-end investment company is created it first
chooses an international investment advisor that decides to buy and sell
securities in the local market utilizing reports statistics and other
investment information from a variety of sources The fund would also
select an Argentine advisor who would provide investment advice research
and assistance as requested The local advisor would be used (although
not exclusively) to execute buy and sell security orders in the local
market
219 The role of an international advisor is needed in order to
provide the investors with credibility regarding the management of the capital Once the advisors have been selected the fund can raise equity
in two ways
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(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
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cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
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have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
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Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
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III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
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Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
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36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
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dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
- 28 shy
(a) Private Placement The fund can privately place its shares with
institutional investors The main advantage of a private
placement is that registration with the SEC is not required and
disclosure requirements are minimal The main disadvantage is
bullthat the country fund will not be known in the equity markets in
the US thereby reducing the impact of the funds success
(b) Public Offering Conversely the fund could issue shares in the
public equity market getting listed and traded in an exchange
The main advantage of a public offering is access to the US
public equity market liquidity in the secondary market trading
of the offering and recognition if the fund performs well The
main disadvantages are the SEC registration procedures and the
listing procedures required to enter an official exchange as
well as the costs of the issue which usually range from 5
percent to 13 percent of the total amount depending on the
underwriting risk in question
220 There are several costs associated with the creation of a country
fund Aside from establishment and incorporation costs the main costs are
the underwriting management and administration costs of the fund
2q21 The underwriting fee is the cost charged by the underwriters in
order to register and sell the shares in the equity market Usually this bull I
fee ranges from 5 percent to 10 percent of the total amount depending on
the risk and salability of the shares This fee reflects the political and
country risk associated with the fund Additionally there is an amount to
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
- 29 shy
cover expenses for the underwriters typically between U3$120000 and
US$210000
222 The managem~nt fee usually ranges between 07 percent and 1
percent of the weekly or monthly average net asset value of the fund
depending on its size and manageability
223 The administration fee is paid to the day-to-day administrator of
the fund Some funds do not have administrators and rely instead on the
managers and the custodians to perform tasks such as transfers of
dividends and so on The administration fee ranges from 10 to 30 basis
points of the average net asset value to the stockholders
224 Although a private placement is less expensive than a public
offering in this case a public offering seems more desirable A public
offering will draw the attention of the investor community at large to
Argentinas efforts to attract foreign investment and if the fund performs
well a public offering will attract more foreign investment into the
country
225 Five of the country funds now in existence were established
during the past three years Country funds (closed-end investment
companies) have been established in the US for Japan Mexico Korea
Australia Italy France Scandinavia and Germany Almost all of these
funds have issued their shares publicly in the US and are active~y
traded Perhaps the biggest success story has been the Korea Fund Since
its establishment in 1984 Korea Fund shares in the New York Stock Exchange
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
- 30 shy
have appreciated over 150 percent in value and the funds success recently
prompted a further public offering of stock The Korea Fund is a special
case vW imiddot since it is the only legal vehicle fur investnent in the
Korean mcet Another key to the success of the Korea Fund is the
bullfavorable economic condition in Korea Over the past three years the
Korean economy has grown more rapidly than the US economy while
experiencing a low inflation rate
226 Other funds however have not been successful A prime example
is the Mexico Fund Organized in 1981 the Mexico Funds original share
price at the time of issue was US$10 It now trades at between US$2 and
US$270 per share a drop of about 77 percent Even though the Mexico Fund
has outperformed the local market it has been subjected to the serious
economic problems of the country including massive foreign debt and poor
exchange rates In 1983 the fund made another stock issue but part of
the underwritten commitment had to be absorbed by the underwriters
227 The funds of Italy France Australia and Scandinavia were
created too recently to establish a market price performance and a net
asset value track record The Germany Fund (which has filed with the SEC
but has not yet issued stock) has not begun to invest yet
228 An international organization could help sponsor the fund through
a guarantee on the net asset value of the fund when the shares are issuedc
If investors had a guarantee for the equity capital fOT one or two years
they would be less hesitant to invest in an Argentina fund The intershy
national organization could also help establish the country fund in the
underwriting and the investment in the fund or both
- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
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bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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- 31 shy
Conclusion
229 There are several possibilities available or financing capital
development Some involve increased emphasis on or a certain degree of
modification to traditional resource mobilization efforts The limited
availability of countries such as Argentina to borrow because of the debt
crisis has spawned many financing options The current efforts at finanshy
cial sector reform in Argentina could include measures to facilitate some
of these options and provide appropriate safeguards
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III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
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Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
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bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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- 32 shy
III DEBT-EQUITY SWAPS
Background
31 When the debt crisis erupted in 1982 commercial banks realized
they were overly exposed in the Third World The fact that much of the
debt carried a sovereign guarantee did not provide much consolation
Debtors saw the flow of privately financed credits suddenly dwindle to the
point that this source of financing for new investment or facilitating
service payments on outstanding credits was no longer available The
situation required adjustments by both debtors and creditors One outcome
was that a secondary market developed for Third World debt
32 Rationalization of Portfolio Some banks swapped their debt in
one country for debt in another so as to eliminate their exposure in
certain countries spread their risk or simplify portfolio administrashy
tion This was done without registering losses even though the secondary
market values were below par value
33 Nationalization of Debt Banks in many debtor countries had also
participated as creditors in the debt run-up through their branches in offshy
shore havens the US and Europe Swapping arra~gements allowed private
banks in debtor countries to concentrate their exposure in their own counshy
try This portion of the countrys external debt then becomes de facto
domes tic loans
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
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- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
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Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
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ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 33 shy
Debt-Equity Swaps
34 The secondary market began to take on added significance when
some countries started to use it for various debt capitalization
schemes~ Brazil was the forerunner in December 1982 Perhaps the best
documented is the Chilean scheme started in 1985~ More recently under
the prodding of commercial banks the secondary market seems to have become
a feature in rescheduling agreements There is little information on the
total sums involved but Chile alone had retired US$1 billion of its debt
by the end of 1986 and estimates suggest total annual trading around 10
times that level There are two broad classes of debtequity schemes
35 Scheme 1--Retirement of Debt In this case a bank converts
existing debt to equity This has been done for example by Bankers Trust
in Chile where it converted external debt to equity participation in a
local pension fund This approach has a number of variants Commonly a
local operator purchases external dollar debt at a discount converts the
face value to local currency at the Central Bank and then uses the
proceeds to reduce domestic debt It is argued that this route could
enable nationals to repatriate some of their external assets In some
instances the gain from the discount may be shared with the Central Bank
For further discussion see Buchleit LC Converting Soverign Debt into Equity Investment International Financial Law Review September 1986 Weinert RS Swapping Third World Debt Foreign Policy No 65 Winter 198687 Larrain FB Market-Based Debt Reduction Schemes in Chile AMa~roeconomic Perspective The World Bank CPD Dicussion Paper No 19872 February 1987
2 For an illustration of transactions under Chiles debt conversion scheme see Attachment 2
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36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
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+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 34 shy
36 Scheme 2--Stimulation of New Investment This second scheme
involves a potential investor The potential investor purchases external
debt (aggin at a discount) obtains from the Central Bank the local
equivalent to the face value and then uses the proceeds for new
investment Again there may be other linkages and agents involved together
with various approaches to divide the benefit from the discount In both
schemes the approach is similar to a corporate restructuring but the
corporation in this instance is the country For various reasons the state
has difficulty in servicing the debt Through debt-equity swaps the debt
is replaced by equity so that in principle the state as a restructured
corporation has the opportunity to recover with a lower debt One must be
careful in extending the analogy too far In particular it should be
noted that in some instances despite the best attempts at restructuring
the corporation does not survive--an unacceptable option in the case of a
country Before discussing the pros and cons of debt-equity swaps it
helps to review the actors
Who Are the Actors
37 Sellers of Bank Loans At this juncture most of the banks
selling their loans are said to be the European or small- to medium-sized
American banks Some banks absorb the loss against profits Presumably
they feel the expense is justified as the price for escaping from costly
intermediate discussions and further pressure to participate in yet another
round o~ reschedulings For many banks however and especially t~r the
major US banks the losses would be unacceptable For them this is a
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
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- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 35 shy
dilemma If they participate in the market thereby acknowledging the
secondary market value of the portfolio they would be faced with a major
writedown On the other hand accountants under shareholder pressure are
obliged to seek full disclosure Consequently there is a great need for
clarification nf the situation by regulatory authorities
38 Investors For multinationals that had already planned
investments for example debt-equity swaps generate a rather transparent
windfall subsidy By going the debt-equity route the multinationals can
obtain the needed local currency at a discount In the case of new
investment the issue is open
39 Debtor Country One cannot say categorically whether debtequity
schemes in general are beneficial for the debtor country It depends on
the particular country and the arrangements for particular schemes
Fortunately many of the advantages and disadvantages can be tailored to
suit a countrys needs A number of commentators have argued that
debtequity schemes simply switch external debt for domestic currency at
the Central Bank which in turn issues domestic debt in order to offset any
inflationary impact on the domestic money stock In many instances
domestic interest rates are significantly higher than rates on existing
debt The outcome is that the total debt service burden on the public
finances is actually increased The obvious benefit of reduced external
debt must be viewed in full context
shyPossible Abuses
310 There is also the possibility that the scheme may be used as a
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
- 36 shy
cover to drain foreign exchange from the country Unless adequate measures
are in place this could be done by using the local currency to buy a local
enterprise and then seeking to remit inflated dividends and profits There
is also the possibility that some funds may simply round trip as the
loc~l currency is converted on the parallel market These abuses are
difficult to protect against One possible remedy is to require a lag of a
few years before allowing remittances It is essential to closely monitor
the parallel market
311 Increased Direct Investment Few can object to facilitating
increased direct investment To the extent that debt-equity swaps can
contribute the process should be encouraged but it is important to make
transparent the public subsidy involved
312 Repatriation of Capital Studies of capital flight have shown
that substantial capital repatriation can only be expected when the
conditions that gave rise to the flight have themselves been reversed
Political and economic stability and a reasonable rate of return are
critical to encouraging capital repatriation While some funds could be
repatriated through the debt-equity scheme this process fails to directly
address the main impediments to repatriation Debt-equity swaps may help
improve the overall investment climate There are questions as to how much
subsidy should be given and--if the objective is capital repatriation-shy
whether debt-equity swaps are a desirable way to address the problem
313 Introduction of New Actors Some consideration should also be
given to replacing commercial banks with multinationals T~e commercial
banks behaved predictably when they did not receive payments as
bullbull
- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull
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- 37 shy
contractors A reduction of the participation of commercial banks could
also reduce the base for future financial packages Furthermore the new
creditors may adopt more forceful methods to recover their assets thereby
jeopardizing the overall process
BenefitsSubsidy
314 A critical factor in determining winners and losers in
debt-equity schemes is the distribution of any benefits Benefits can be
estimated through this simplified analysis Assume a debt of US$ B face
value is sold at a discount d The debt is then exchanged at the central
bank at the-_ offioial exchange rate eLet us assume that the unofficial
or parallel foreign exchange rate has a mark-up m above the official rate
Case A If the mark-up m = 0
Benefit element is dB in US$
Gross return d fd
Case B m 0
Benefit element is d B in US$
+ m
Gross return d - shy
- d + m
- 38 shy
Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
bull
- 39 shy
316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
bull bull
- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 1 Page 2 of 6-43shy
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
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Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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Numerical example Let B be US$100
Suppose discount is 3 (30)
Let parallel exchange rate mark-up be 2 (20)
A ~~--
Benefit is $30
Return is 043 (4~
Case B Benefit is $25
Return is 036 (36)
Note that as the parallel and official rates diverge the available benefit
and the gross return are reduced It is evident that debt-equity swaps
would lose much of their attraction if the mark-up in the parallel market
were close to the offered discount The parallel rate is also a strong
indicator of the perception that economic policy is (or is not) on track
Burden on Public Finances
315 In order to estimate the burden of debt-equity swaps on public
finances one must examine the particular circumstances If it is not
necessary for the Central Bank to issue offsetting domestic bonds to
control liquidity then the burden is reduced But this in turn would
require that the fundamentals be in place in other words the fiscal
deficit must be under control at an acceptably low level This is not the
situation in most debtor countries so that the reduction in external debt
must be offset at least partially by a corresponding increase in domestic
debt The ratio of real domestic to foreign interest levels idif bullbull
gives a measure of the increased cost if the domestic debt is used to
offset 100 percent bull
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316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
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- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
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- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
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ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
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Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
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Attachment 3
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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316 In the example quoted above the change in annual interest costs
I on a bond with face value US$B is given by
I = B (idjif - 1) $ equivalent
317 This direct burden may be reduced by using domestic debt for only
a partial offset One could envisage a scheme similar to the Chilean
system where a budget would be allocated for such deals and prospective
clients invited to bid This would implicitly allow the Government to
capture part of the benefit
318 If only a fraction f of the debt-swap is offset by domestic
debt then the change in annual interest costs would be modified to I
where
1m B (f ~ - 1) if
Thus if the debt swap is completely offset (f 1) the total interest
burden 1m after the swap would normally be higher than before the swap
Institutional Aspects
319 Before embarking on a debt-equity scheme there are a number of
factors to consider It is essential to define the rules of the game
This would include the legal framework and how the benefits are to be
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- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
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- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
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ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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- 40 shy
divided The legal framework used in Chile is given in Attachment 2 Key
factors that should be determined beforehand include
(a) Exchange Rate The exchange rate that will be used should be
defined If the official rate is chosen the participants will
need to include the parallel market mark-up to evaluate their
return
(b) Money Supply It is important to decide how much of the external
debt-swap will have to be offset by domestic debt to meet
domestic money supply targets There must also be a domestic
market to absorb the required change in domestic debt
(c) Policy FrameworkAdministration Procedures If the scheme is to
be attractive to foreign investors or help reverse capital
flight there must be amiddotconsistent policy framework in place It
is also essential that administrative procedures not frustrate
these efforts
(d) Public Sector Cost It is important to estimate the costs of
servicing the reconstituted debt and seek to keep domestic real
interest rates low enough to avoid any unreasonable increase in
the public sector burden
(e) Addit~onal Funds If a country requires anypebt-equity swap
to be accompanied by new capital inflow this will modifY the
attractiveness of such a scheme
bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
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Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
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bull bull bull bull
- 41 shy
Conclusion
Debt-equity swaps are an interesting new development with
advantages and disadvantages that depend on the particular country and the
countrys economic policy There are benefits available and experience
suggests that they can be divided between the participants the commercial
banks prospective investors and the debtor country In view of the
possible impact on the exchange rate domestic liquidity and public sector
deficit it is important to try to define the limits for acceptable schemes
as clearly as possible ahead of time
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
bull
bull bull
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
bull - ~ -
ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U S
PERIOD 1977-1985
Multiples
Net Income Book Value Sales
High 737 62 18
Average 208 236 96
Low 64 8 2 I
+shyN
Value of Petroquimica Mosconi on a Comparable Acquisition Basis I
(US$ Million)
Net Income Book Value Sales
High 5700 1534 2460 MM
Average 1608 584 1309
Low 495 198 210 dgtIII rt
OQrt f1) III
Petroquimica Mosconi Financial Data as of 123185 s ()r
(US $ Million) o f1) mJ
rt 01
Net Income $ 113 Book Value $2414 Total Sales $1364 5409jl
bull
bull bull
bull
bull bull
Attachment 1 Page 2 of 6-43shy
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
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Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
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-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
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The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
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bull
Attachment 3
Page 3 of 4 -S6shy
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
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The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
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6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
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Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
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Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
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i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
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willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
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Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
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Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
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Attachment 2 Page I of 6
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ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
bullbull
Attachment 1 Page 6 of 6
-47shy
Ibull
li --~ i ~
i i i
bull
w
bull bull
Attachment 2 Page I of 6
-48shy
ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
bull bull
Attachment 2 Page I of 6
-48shy
ILLUSTRATION OF TRANSACTIONS UNDER CHILES DEBT CONVERSION SCHEME
This Annex describes the structure of typical conversion transactions under Chapter XVIII and Chapter XIX of the Banco Centrals foreign exchange regulations Before detailing the steps in a representative transaction under each Chapter the parties involved are described
Debt Capitalization (Chapter XIX)
Parties Involved 11
1) Foreign investor who has an investment opportunity in Chile and requires local currency at least equal to the amount of the debt transforcation transaction
2) Foreign broker who deals in LDC debt and has or can find a creditor who is willing to sell the debt at a discount
3) Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4) Chilean debtor who must be as direct obligor the Treasury the Central Bank a public sector entity a bank or financial institution authorized to operate in Chile or a private sector debtor whose debt was guaranteedby the government a bank or financial institution prior to July I 1985 and is willing to accept redenomination of the foreign debt in local currency
5) Chilea~ bank who is given an irrevocable mandate by the foreign investor to carry out the redenomination of the foreign debt obtain local currency payment or a new local currency debt instrument and carry out the investment
In ~he two examples given in this Annex different and unrelated entities are assumed to play the role of each party to the transaction Often in practice the same entity (including its affiliates) can perform more than one of the distinct functions and thereby increase its share of the gains from the transaction For example a foreign commercial bank that owns a bank in Chile which is active in the domestic financial market can fulfill the roles of thebull foreign agent the foreign creditor bank the Chilean bank and the Chilean agent Or in another example a Chilean bank that is guarantor of the foreign debt of a corporate client in financial difficulty can take advantage of either Chapter XIX or Chapter XVIII to help with the financial restructuring of its client bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 2 Page 2 of 6
-49shy
6) Chilean broker who acts as advisor to the investor and may handle the placement of r~e newly created local currency debt instrument
7) Central Bank who authorizes each investment through debt conversion on a case-by-case basis In practice the principal criterion that determines the eligibility of a proposed investment is whether it represents new money that would not otherwise have been invested under the normal foreign investment ~ode (DL-600)
TranscCiOD Steps for Debt CapitalizatioD (Chapter XIX)
Step 1 Foreign investor contacts the foreign broker to find an eligible Chilean foreign debt instrument available for prepayment at a discount The foreign investor must use his own external funds to acquire the debt instrument The foreign broker collects a fee of 1 (usually) for completed transactions
Step 2 Once the foreign broker has located an appropriate debt instrument the foreign investor obtains the agreement of the Chilean debtor to redenomination at face value of the external debt into local currency at the official exchange rate
Step J Foreign investor applies to the Central Bank and obtains an authorizacion to make an investment in Chile with theiocal currency proceeds of the debt capitalization transaction The application must identify all parties and describe the transaction in detail and provide appropriate information on the proposed new investmenc The foreisn investor must also accept restrictions on the repatriation of profit (4 years) and capital (10 years) and if deemed appropriate by the Central Bank agree to waive che free repatriation provisions of DL-600 that govern other previous investments made by he investor Furthermore the Central
bull ~ may require that SOme part of the investment be made 1n freely convertable foreign exchange
Step 4 The foreign investor purchases a foreign debt obligation of (eg) U5$10000 from a foreisn creditor ~ through his foreign agent for (eg) U5$7000 and pays a commission of (eg) US$70 (1) The purchased note is delivered to the Chilean bank
Step 5 The foreign investor gives an irrevocable mandate o the Chilean bank to (i) collect in cash the face value of the redenominat~d note or (IT) exchange it for a new debt instrument payable in local currency UF (indexed units of exchange) or foreign currency payable in local currency at terms and conditions negotiated with the debtor If the C~ntral ~ is the debtor on the loc~l currency debt instrument the tems ~re fixed by tegula~ion otherwise domestic financial market conditions prevall -Bearer instruments may be used The purchased note is delivered to the Chilean ~
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 2 Page 3 of 6
-50shy
Step 6 The Chilean ~with the prior agreement of the foreign creditor bank and themiddotChilean debtor redenominates the debt in local
bull currency qual to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 7 The Chilean ~ creates a new local currency debt instrument with the Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 8 The Chilean broker places the UF debt instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank with a mandate to disburse the funds directly for the acquisit~of equity shares (or other approved form of investment) A commission of about 1 On the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655 for investment bull
Step 9 The equity shares or other evidence of the investment are delivered to the foreign investor
Financial Suary of the Debt Capita11ation Tranaction (Valued in local currency at the parallel exchange rate)
PortlD creditor bank -Holds debt obligation of US$10000 which would have been paid at the official exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps 14 z070
-Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of the discount Ps 4929
Distribution of Value of the Discount
Foreign Investor Paid to purchase debt Ps 14070
Commission 201 Ps 14271 Received for investment V Ps 17 1655
Investors net gain Ps 3384 Domestic Broker commission l01bullDomestic financialmarket discount 1 z344
Ps 4929
21 See Step 8
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 2 Page 4 of 6
-51shy
Foreign investor effective exchange rate Invests foreign exchange of U5$7070 which otherwise would have yielded Ps 1357440
Official exchange rate- 192 Through debt capitalization actually received in local currency P51 1765500
Effective exchange rate 250
Debt Conversion (Chapter XVIII)
Parties Involved
1 Chilean investor who wishes to take an internal profit on the discount available in the international market for Chilean foreign debt obligations (or to convert his own debt at a discounted value) The Central bank state-owned entities and Chilean banks are prohibited from doing these transactions for their own account as are individuals with a significant financial interest in Chilean banks unless they receive prior Central bank approval
2 Foreign broker who deals in LDC debt and has or can find a creditor willing to sell the debt at a discount
3 Foreign creditor ~ who either holds Chilean debt in portfolio or swaps other LDC debt for Chilean debt and is willing to sell such debt at discount
4 Chilean debtor who is the direct obligor either as a private sector or a public sector borrower on a foreign debt instrument payable abroad for an original or extended term of over 365 days and registered as required by appropriate regulations
5 Chilean ~ who is willing to accept an irrevocable mandate from the Chilean investor to carry out the redenomination of the foreign debt and obtain local currency payment or a new local currency debt instrument
6 Chilean broker who acts as advisor to the investor and handles the placement of the newly created local currency debt instrument
7 The Central Bank who auctions to banks the right to intermediate the conversion of a foreign debt obligation to a local currency obligation Currently the Central Bank holds bimonthly auctions and limits the total amount of rights granted to a total of U5$60 million per month of the discounted value of foreign debt obligations
Transaetion Step for Debt COnversion
Step 1 The Chilean investor contacts the foreign broker to find an eligible Chilean foreign debt investment available for prepayment at a discount
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
middot Attachment 2 Page 5 of 6
-JLshy
i r
Step 2 Once the foreign broker has located an appropriate debt investment the Chilean investor obtains the agreement of the Chilean debtor to redenominltation at face value of the external debt into local currency at the official exchange rate
Step 3 The Chilean investor gives an irrevocable mandate to the Chilean bank to (i) collect in cash the face value of the redenominated note or TIIT to exchange it for a new debt investment payable in local currency UF (indexed units of exchange) or indexed foreign currency payable in local currency at terms and conditions negotiated with the debtor If the Central Bank is the debtor on the new local currency debt instrument the terms are-Fixed by regulation otherwise domestic financial market conditions prevail Bearer instruments may be used
Step 4 The Chilean ~ submits a sealed bid to the Central ~ which sets forth the total face value in foreign currency to be paid to acquire the foreign debt instrument for the Chilean investor (eg) US$7000 and the price (ie commission as a percent of the acquisition cost) that he is willing to pay to the Central Bank for authorization to convert the debt to local currency (eg) 15
Step 5 The Central ~ selects sufficient bids beginning with the highest offered price (commission) and taking the next lowest bids until the tntal amount preallocated to the auctions is fully utilized and then notifies the corresponding Chilean banks These rights may be transferred to other banks The Central bank debits the account of the Chilean bank fo~ the commission of Ps 211050 (15 of the authorized amount) an~ value added tax on the commission of Ps 42210 (20)
Step 6 The Chilean investor purchases the foreign debt obligation of (eg) USSLOOQO from a foreign creditor ~ through his foreign broker for (eg) U3S7000 and pays a commission of (eg) US$070 (1) The pJrchased note must be delivered to the Chilean ~
Step 1 The Chilean ~ with the prior agreement of the foreign creditor bank and the Chilean debtor redenominates the debt in local currency ~l to the face value of the foreign obligation converted at the official exchange rate (now Ps 192) or for Ps 1920000 leaving all other terms and conditions standing thus the foreign exchange obligation is transformed
Step 8 The Chilean ~ creates a new local currency debt instrument with th~ Chilean debtor as direct obligor payable to bearer and denominated (eg) in UF and payable for example over 15 years The foreign debt instrument (now denominated in local currency) is cancelled and the new UF debt instrument is delivered to the Chilean broker
Step 9 The Chile~n groker places the UF debt_instrument in the domestic financial market at (eg) 93 or Ps 17856 which is delivered to the Chilean bank for disbursement to the Chilean investor A commission of about U()[1the face value or Ps 20100 is deducted for transaction costs leaving net proceeds of Ps 17655
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 2 Page 6 of 6
f f
Step 10 The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps 211050) and the value added tax (Ps 42210) a~d pays the Chilean investor the balance of Ps 1512240
Financial Suary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate)
Poreign Creditor bank
-Holds debt obligation of US$10000 which would have been paid at theofficial exchange rate Local currency value Ps 19200
-Receives payment of US$7000 which has a value at the parallel exchange rate of Ps bull 14070 -Discount valued in local currency Ps 5130 -Less Commission to foreign broker 201 -Value of discount Ps 4929
Distribution of Value of Discount
Chilean investor Paid to purchase debt Ps 14070 Plus commission Ps 201 Ps 14 27 100
Net local currency received 11 Ps 1512240 Net gain for Chilean investor 85140
Central bank commission Ps 2~ 11050 Domestic~ker commission 20100 Government value added tax 42210 Domestic f1nancial market d1scount i34400
Ps~ 492900
~ See Steps 9 and 10
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment Page 1 of
-)4shy
-LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl
General
101 The legal framework for the capitalization of Chilean foreign exchange debt is provided by the following instruments
Decree law 600 (1974) which enables a creditor holding foreign currency-denominated paper of a Chilean debtor to convert such obligation into an equity holding in the enterprise of such debtor and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XIX (of Banco Central de Chiles Compendium of Rules on International Exchange) which enables a holder of foreign currency-denominated paper of prescribed categories of Chilean debtors to convert such paper into Chilean pesos or peso-denominated paper for the purpose of investing in Chilean enterprises and permits subject to certain restrictions the remittance abroad of capital and profits
Chapter XVIII which permits the conversion of foreign currency-denominated paper into peso-denominated paper but which need not be used for investment purposes and makes no provision for remittances abroad
In order to permit conversions of foreign debt without trigerring mandatory prepayment clauses contained within restructuring or involuntary new money facility agreements enabling provisions have been provided in the relevant agreements
DL 600
102 DL 600 is the principal law governing direct foreign investment in Chile Among the various forms of transactions explicitly stated to constitute foreign investment is the capitalization of foreign debts The law is designed to attract foreign inveatment and therefore contains a number of intended inducements including the following
The investment authorization is evidenced by a contract between the Chilean state and the investor (This is thought to provide a major legal protection for the foreign investor against subsequent changes in the law which might affect the terms under which the investment was made eg terms affecting remittance rights)
Restrictions on remittance rights are limited to a 3bull year prohibition on capital transfers_from the date of bullinvestment
Ll Source World Bank Debt Conversion Chile Paper prepared by VPCAU LEGVP FPA September 1986
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 3 Page 2 of 4
-55shy
The investor may opt to include in the investment conLrac~ 4 tax provision locking in for a 10 (and in certain cases 20) year period a prescribed income tax treatlLer1 for the investment The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile
103 For the creditor who wishes to reduce its overall exposure to Chile by effecting a debt-equity swap however DL 600 possesses a major limitation the swap may only be effected in respect of the debtors own capital
Chapter XIX
104 Chapter XIX permits individuals and legal entities resident and domiciled abroad to use foreign currency-denominated debt instruments for the making of iavestments ia Chile Unlike OL 600 such investments may be made in an entity other than the debtor under the foreign currency-denominated debt instrument The main features of a Chapter XIX transaction are as follow
The foreign currency-denominated debt instrument being utilized must have as debtor the Chilean state public sector entities financial entitiea authorized to operate in Chile or private sector entities whose obligations have been guaranteed by such financial entities prior to July 1 1985 The creditor wishing to make the iavestment must enter into an agreement with the debtor for the conversioa of the payment obligation fro a foreign currency into a peso obligation The repayment terms may be varied by such contract including full prepayment An express waiver to aay right of access to the foreign currency market for payment of the debt must be included in this agreement
Each investment conteplated under Chapter XIX requires Banco Central approval
Capital may only b remitted abroad 10 years after completion of the investment Dividend remittances abroad are permissible at the end of 4 years Divishydends accumulated prior to such date may only be
bull remitted in 25 annual installments commencing the fifth year
105 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomishynated obligation at ~ discount (eg hecause the seller Ls
t
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 3
Page 3 of 4 -S6shy
J
bull
willing to take a hit in order to reduce or eliminate its portfolio of Chilean paper) and agree with the original debtor to obtain peso payment at a rate equivalent or near to the original face value of the debt instrument and then utilize the peso holdings for such investments as it may wish bull
Chapter XVIII
106 As is the case for Chapter XIX Chapter XVIII permits individuals or entities to purchase foreign currency-denoa1nated debt instruments of any Chilean debtor (state public or private sector) for conversion of the payment obligation froa a foreign currency into a peso obligation The difference between Chapters XVIII and XIX are as follows
the peso proceeds need not be used for investaent purposes
there is no right of access to foreign exchange for eventual repatriation of principal or earnings
no Banco Central approval is required However the Banco Central controls the voluae of transactions through an auction system which it conducts on a bi-weekly basis (as of July 2 1986) (See further Annex 3)
The absence of remittance abroad rights reflects the fact that Chapter XVIII is not in the main addressed to foreign investors but to reSidents including flight capital (see further Annex 3)
Enabling Provisions in Restructuring and Involuntary New Money Agreements
107 In 1985 Chile (including public sector and private financial sector borrowers) and its international creditors agreed to the insertion into the new money and restructuring arrangements of provisions permitting Chapters XVIII and XIX transactions and expressly stating that such transactions will not trigger the mandatory prepayments provisions of the relevant agreements (see eg B-Loan B-IO Sections 402 (b)(iii) and 511)
108 Because an uncircumscribed debt-equity conversion could place the creditor whose debt is being converted in a more advantageous pOSition than other creditors with respect to eventual recovery of assets (if capital and dividend remittances abroad are unrestricted) agreement by the international creditors to the operative provision in each of these 1
arlangements was premised upon acceptable l(mitations on remittance rights being included in Chapters XVIII and XIX Chapter XVIII permits no remittances abroad and therefore clearly satisfies the concerns of creditors The remittance restrictions in Chapter XIX (see above) reflect the following considerations
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
Attachment 3 Page 4 of 4
-57shy
The 10 year capital remittance restrictions approximately reflects the average life of new tloney loans
The 4 year dividend remittance restriction represent a trade-off for the fact that because the conversion reduces or eliminates the exposure of the relevant creditor to Chile the liability of such creditor to new exposure (through involurampry new IIOney calls) is is reduced or eliminated
l
r r
bull
