66410 Department Discussion Paper 1 AB.GENTIHA, ECONOMIC RECOVEl.Y AND GROW'l'B 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 Bar.k. 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 ·findings, interpretations, and conclusions expressed in this paper are entirely those of the authpr(s) and shouldt.not be attributed in any manner ~ • to the World Bank. to its affiliated organizations. or to members of its Board of Executive Directors or the countries they represent. GLOSSARY OF ACRONYMS AACRE Asociacion Argentina de Con Argentine Association of sorcios Naciona1es de Expe Regional Experimental Con rimentacion Agricola sortia • ADMIRA Asociacion Meta1urgica Argentina Argentine Metallurgy Association ANA Administracion Naciona1 de National Customs Administra Aduanas tion BANADE Banco Naciona1 de Desarrollo National Development Bank BCRA Banco Central de 1a Republica Central Bank of Argentina Argentina BONAVI Bonos Naciona1es de Intereses variable interest rate bonds Variables BONEX Bonos Externos foreign bonds (US dollar denominated Government bonds) CEM Country Economic Memorandum CEN Corporacion de Empresas Corporation of National Naciona1es Enterprises CEPAL Comision Economica para Economic Commission for Latinoamerica Latin America (ECLA) CD Certificado de Deposito certificate of deposit CGIAR/CGR Consultative Group on Inter national Agricultural Research CGT Confederacion General de Trabajo General Confederation of Workers CKD completely knocked down CONADE Consejo Naciona1 de National Development Desarrollo Council CPI consumer price index CRM Cuenta de Regu1acion Monetaria Monetary Regulation Account (Interest Equalization Fund) DGI Direccion General Impositiva General Tax Directorate DIF Deposit Insurance Fund DJAT Dec1aracion Jurada de temporary admission import Admision Temporaria request DJNI Declaracion· Jurada de import permit Necesidades de Importacion DNPC Direccion Naciona1 de National Directorate of Promocion Comercial Commercial Promotion FIEL Fundacion de Investigaciones Latin American Foundation Economicas Latinoamericanas for Economic Research FONAVI Fondo Naciona1 de Vivienda National Housing Fund FUNDECO Fundacion Economica Economic Foundation GATT: General Agreement on Tariffs and Trade • GOP ". gross domestic product GDFI gross domestic fixed investment IBRD International Bank for Reconstruction and Development IDB Inter-American Development Bank IFS International Financial Statistics IlCA Instituto Interamericano de Inter-American Institute for Cooperacion Agricola Agricultural Cooperation IMF International Monetary Fund INDEC Instituto Nacional de National Institute for Stat Estadistica y Censo istics and Census INPE Institute Nacional de National Economic Planning Planeamiento Economico Institute INTA Instituto Nacional de National Institute for Agri Tecnologia Agropecuaria cultural Technology IVA Impuesto de Valor Agregado value-added tax JNC Junta Nacional de Carnes National Meat Board JNG Junta Nacional de Granos National Grain Board LIBOR London Interbank Offer Rate M< medium and long term MCBA Municipalidad de la Ciudad de Municipality of the City Buenos Aires of Buenos Aires NADE Nomenclatura Arancelaria de Customs Classification for Exportacion Exports NFS nonfactor services PAN Programa Alimentario Nacional National Food Program PEA . Poblacion Economicamente Activa economically active population PRESEX Programas Especiales de Special Export Program (PEX) Exportacion RER real exchange rate REER real effective exchange rate SIC Standard Industrial Classification SICE Secretaria de Industria y Secretariat of Industry Comercio Exterior and Foreign Trade SIGEP Sindicatura General de General Comptroller of Empresas Publicas Public Enterprises SITC Standard Industrial Trade Classification SKD semi-knocked down SMI small and medium-size industry SNESR Servicio Nacional de Economia National Rural Economic y Sociologia Rural and Sociological Service TAR Temporary Admission Regime trade policy VA value added '. VAT I value-Added tax .. VNA Valores Nacionales Ajustables indexed national bonds WPI wholesale price index YPF Yacimientos Petroliferos state oil company Fiscales 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 (Labor/Em~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. Privatization Unit •• ... ... .. II. Innovative Financing Techniques 18 III. Debt-Equity Swaps • 32 .' I. PRIVATIZATION UNIT 1.1 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 enter 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. 1.2 Composition. The privatization unit is normally composed of fi nancial analysts and experts in specific industrial sectors (petrochem 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. 1.3 Tasks. The major task of the unit would be to design and imple 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 (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. t.4 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 , , • - 3 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 12,000 8,000 4,000 40% 151,200 Steel 1 12,000 8,000 4,000 40% 33,600 Total 10 184!800 /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 1.5 Privatization programs require diverse and specialized disci 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 back grounds in the preparation of information, in the appraisal of assets, in the design of sectoral strategic studies, and in the execution of divest i ture programs might be looked upon as providers of needed services. .' (a) • Auditors. The supply of accurate and updated financial informa , tion is a key requirement'in any type of divestiture process. To - 4 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-con trolled sectors, so policies can be designed to encourage private • investment. The scope of these measures may involve, but is not limited to, specific pricing recommendations, labor and manage 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. - 5 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 1.6 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 (e.g., labor disputes or intercompany transactions). Unless one has already been completed, a financial audit may also be required at this stage. • • f Restructuring. • t • To make the enterprise more attractive to poten tial buyers, and maximize the value of the sale to the shareholders, cer 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 (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~J<.a.t::lt. The merits of each must be examined in the context of Argentina's labor situation. Addi 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 9:1 debt to equity ratio and other drawbacks was converted through accounting adjustments into a~}more attractive 3:1 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 (e.g., 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 palm I t • • • • 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 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 company's 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. 1.8 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 • , , . 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 discount rate and the terminal value (the factor by which the last year's earnings are multiplied). In countries such as Argentina where inflation rates are high, attention I:lhould De focused on the short-term horizon, as long-term earnings tenJ ~o have only a marginal impact on the present value of an enter 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 enterprise's yalue with its potential for cash ~ • " t • generation. As a Spanish Government official said in response to accusations that Rumasa's assets were underpriced, "If one were to base price on replacement cost, all these companies would - 9 probably be worth billions of dollars, since the processes and skills required to rebuild them are no longer in existence." Book &nd liquidation value are two other assessments commonly used in evaluating companies. 1.9 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/ -Industrial economy British Telecom international equity -Large and highly offering liquid local equity market -High growth sector -Profitable company Integrated domestic/ -Small size of local Rumasa international direct equity market sale -Loss-making condition of companies Domestic equity -Relatively large size Mexico's offering of local equity market reprivatization -Size of issue of corporate holdings of the banking sector Domestic direct sale -Scope of business Canada-Northern -Large size of local market Transportation -Expressed interest of Corporation local investors Limited .. normally encompasses the following functions: - 10 (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 enterprise's 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' perceptio"ns about the enterprise's 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 enterprise's 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 Argentina's 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: • . (i) Integrat~d Domestic/International Equity Offering. This type of strategy was employed by the Government of Table 3: Sample List of Potential Buyers for Pmoguillliea HoS:.lUt:con:.:. :,. l_ _ (US ~ Hi11ion) CO/IIDany Iota) Assets DescrtDtton or Bus'n.ss 1, 'elanese.Corp. Hanufactures and sells a diverstfied ltne of chemicals, ftbers and specialty products. Hajor ",orld producer of these items. 2' PPG Industries 1.783HH Engaged 'n three bustnesses: 1) Hanufacture of fiberglass and flat glass. 2' Produces protective and decorative finishes for autos, 3) Nattonal Dtsttllers 1,853HH Produces and markets petrochemicals. dtsttlled sptrtts and imported ",'nes. & Chemtcal Corp. 4) Do,", Chemt ca 1 12.388HH Engaged 'n the manufacture and sales of chemtcals, plasttc matertals. agricultural and consumer products and other specialtzed products. 5' ~tsut and Co. 25.617HH World",tde tradtng of commodlttes. Acts on orders from tts customers or developed through tts o",n sales net",ork. Involved in shtpping. ftnancing and also 'n development and procurement of natural resources, petrochemtcal grains and lumber. 6' Koppers Co. Inc. 1,177HH Engaged tn productng and marketing specialty chemtcals and plastics for set products, road matertals. engtneered metal products. 7) 01 tn Corp. 1.602HH Hanufactures chemtcals such as urethane. organtc and agrtcultural ch~micals. Hetal pro ducts as ",ell. 8) Pennzotl 3,224HH En,aged in otl and gas exploratton and product ton. proceSsing. refining and markettng of oil and gas and reftned products. ') Atlanttc R'chfteld 21,842HH Engaged tn oil and gas exploration, development, reftning and transportation of petroleum ltqutds and natural gas as ",ell as mtntng (also in manufacturing and marketing petrochemical products such as .aromattcs. olefins, oxygenated intermedlals and polymers. 10) W.R. Grace and Co. 5.685HH Hanufactures and sells chemicals. Suppltes servtces and equipment to petroleum· industry as ",ell as exploring for otl. gas and coal. Diversifted. 11) Hercules 2,543HH Hanufactures and sells chemtcals and all ted products. includlng organicS. plastics. ",ater soluble products. explostves. etc. 12' Unton Carbtde IO,127HH Engaged in resei\rch. development. manufacture and sale of chemIcals and plastics. industrlal gases and related products. metals and carbons. and SPcCially products. 11) Honsanto Co. 9,941HH industrial chemicals. including detergent and specialty chemic,lls. polymer products, including plast iCs. resin products and chemicals and instrumenb. Ocvclops eleclromc process controls. SJ41jll Table 3: Sample list of Potent;al Buyers for Petroauimica Hosconi (US $HilHon) .. Company Total Assets OescrlDtton of Business . 14) GenCorp 1.984HH Diversified company. manufacturing passenger and truck tires, chemlt~ls. plastics and (altas General Tire industrtal products for auto, construction, appliance, and defe~se products, among & Rubber Co.) others. ' 15) Wltco 783HH Hanufactures and markets specialty chemicals, polymers, and petr~chem\cals. (formerly Wttco Chem'cal Corp) Hi) Tenneco 20.282HH Processes. refines and markets oil and refined petroleum products. Manufactures and I\) sells organtc and inorganic chemical products, construction and farm equ'pment. Engaged also in the financial service industry. '7) Cabot 1.629HH Operates in the field of energy, engineered products and perfonmance chemicals like various polymers and various energy absorbtng products and fumed silica. Diversified concern. 18) Atr Products & 2.687HH Engaged primarily tn supplying tndustrlal gases. Industrial processes and other Chemical Inc. equipment and related engineering services, chemical products and construction. 19) OCCidental Petroleum 12 .417HH 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. plastics and metal finiShing products. • 20) Diamond Shamrock 4,556HH Exploration for and development of various natural resources. Also refining and selling commodity and specialty chemicals. - 13 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 0.5 billion was made simultaneously in the UK, US, Swiss, Canadian, and Japanese equity markets. The unprece dented size of the issue, and the ability of the U.K. Government to pursue a market-oriented, internationally integrated approach was due· 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 Domestic/International 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 (iii) Domestic Equity Offering. This approach was pursued by the Mexican Government in the reprivatization of co!'porate holdings that were taken ov:;r 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 country's 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 enterprise's 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. .. (d) Executing Marketing Program. t • Implementing the marketing program- is usually the most time-consuming task in a privatization ef fort, and it often involves not only distributing sales brochures - 15 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. 1.10 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 no 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, mainte 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 Government's preference regarding these criteria should be de fined beforehand and made clear to potential buyers. 1.11 Fairness Statement. Once an offer is accepted, a formal state 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 1.12 Closing. Once an ?ffer has been accepted, the official transfer of assets is executed. This procedure, regarded as the closing period, re - 16 quires the participation of lawyers and accountants. The lawyers for both the seller and the buyer draft and execute the transfer-of-ownership con 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. 1.13 Table 4 shows a b~eakdown of the various stages involved in di 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. - 17 1.14 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 tl.<::: efficiency and skill with which the process is handled. • •• - 18 II. INNOVATIVE FINANCING TECHNIQUES 2.1 This secticr- fiscusses a number of possibilities for improving Argentina's 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 2.2 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, C.F., Cline, W.R., and Williamson, J., Bank Lending to Developing Countries: The Policy Alternatives, Institute for t Interna~ional.Economics, 'ashin~on, D.C., April 1985. • I. Lessard, D.R., and Williamson, J., Financial Intermediation Debt Crisis, Institute for International conom~cs, September 1985 • • < ~. • .~ " - 19 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. 2.3 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 2,000 leasing companies. The advantage to lessees in manufacturing or construction is that they reduce the need for capi tal loans they might not be able to get for security reasons or because of limited access to the necessar.r 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 these, leasing is an off-balance sheet operation. The lessor benefits b.r including a mark-up for his package, and has title and recourse to the items financed. In short, leasing channels finallcial bbviul:So into produc ti ve investment. For Argentina, the concept could concu::' ·".b!y be extended to make the Government the lessee. This would in effect be a forward-look ing, debt-equity saving, yielding new capital rather than a financial re ordering of existing stock. Housing Fund 2.4 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. 2.5 Ironically, there are major flows of funds to two of the institu tiona involved: the Banco Hipotecario and FONAVI. The Banco Hipotecario is a major recipient (over A 1 billion) of rediscounts, while FONAVI bene 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 pro ( 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 Table 5: 'l'YPICAL PROJECT STYLE FINANCING Cogas co .5.1.. Entidad Binacional Yacyreta Project Description: Gas pipeline project Hydroelectric project Project Sponsors: Nascap B.V. (Netherlands) 70.0% Argentine Republic 50.0% Tecasa S ..... (Argentina) 20.5% Republic of Paraguay 50.0% Pamar 5..... (Argentina) Project Location: Argentina Argentina/Paraguay Project Vehicle: Corporation Binational entity Total Debt Financing: $875,000,000 (equivalent) $2,176,000,000 Import/Export Credit and Dfls. 1.100,000.000 of Dutch export $826,700,000 of export credits Other Debt Sources: credit facilities $708,500,000 World Bank direct $100.000,000 of Dutch export credit loan and co-financing facUities $420,000,000 lADB direct loan and complementary financing Y5,OOO,OOO,OOO Japane.e private placement Bank Loan Component: Type of Loan: Syndicated lac Syndicated loan Amount: $85,000,000 syndicated term loan S200,OOO,OOO $65,000,000 short term 'loan $75,000,000 standby facility Maturity: Up to 7 years .12 Years Recourse after Completion Limited recourse to Argentine Argentine Republic guarantee Republic non-recourse to contractors. ll1slts Assumed by lanka -COmpletion ·Uninsurable 'orce Majeure ·Political risk Lenders: Lead Banks: Amsterdam-Rotterdam Bank (Agent) Horgan Guaranty (Agene) Lloyd. Bank International Bank of Tokyo Citibank Hitsubishi Bank Royal Bank of Canada Union lank of Switzerland ...ugust 15. 1986 • I. - 22 2.6 In the meantime some of the more successful approaches to hous ing finance warrant consideration. In the-early 1970s, Colombia's housing sector faced problems similar tv those faced by Argentina today. In parti 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: UPAc.71 UPAC 2.7 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. 2.8 A key feature in UPAC's 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 UPAC's meager beginnings in 1972, savings grew to US$3 billion by 1985, and the number of depositors went from 60,000 to 3.5 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, L.E., Instituto Colombiano de Ahorro y Vivienda, Bogota, 1986. A more technical description is given by Gomez, C.A.Z., La Correccion Monetaria y el Credito en UPAC, Bogota, 1986. - 23 in housing and enabled housing, to serve as a leading sector in the reactivation of the economy. Country Funds 2.9 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 invest 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. 2.10 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. 2.11 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 auth orities are that the fund: • I. (a) Is the most effective method of raising equity capital from international securities markets. Until international investors - 24 become familiar with a country's securities market, alternative equity securities such as shares or convertible bonds issued by c?wp~=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 currency• • I. The control aspect of the country fund is all the more critical in today's uncertain international environment, where speculative investment has become widespread among even the largest - 25 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 manage ment and by institutions of the country concerned. Together they provide the investor with expert management, adapted to the envi ronment of the particular country's market, which the individual foreign investor would be unable to provide himself. 2.12 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 Argentina's set up a country fund that declined 77% in market value since its establishment in 1981. - 26 B. Purpose of the Argentine Fund 2.14 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 Argentina's stock market has a total market capitalization equal to US$1.6 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 Argentina's debt, and virtually no foreign investment would have been achieved. 2.15 Equity capital is the preferable form of capital for the current stage of Argentina's 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 Argentina's severely limited sources of foreign investment. C. Procedures to Establish a Country Fund 2.16 The procedures to establish a country fund vary depending on whether the country prefers to issue the securities to the public (as in - 27 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. 2.17 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. 2.18 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. 2.19 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 (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 • that the country fund will not be known in the equity markets in the US, thereby reducing the impact of the fund's 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. 2.20 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 • 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 cover expenses for the underwriters, typically between U3$120,000 and US$210,000. 2.22 The managem~nt fee usually ranges between 0.7 percent and 1 percent of the weekly or monthly average net asset value of the fund, depending on its size and manageability. 2.23 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. 2.24 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 Argentina's efforts to attract foreign investment, and if the fund performs well, a public offering will attract more foreign investment into the country. 2.25 Five of the country funds now in existence were established during the past three years. Countr,y 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 stor,y has been the Korea Fund. Since its establishment in 1984, Korea Fund shares in the New York Stock Exchange - 30 have appreciated over 150 percent in value, and the fund's success recently prompted a further public offering of stock. The Korea Fund is a special case, :!vW"' ..... i·, since it is the only legal vehicle fur investn,ent in the Korean mc..!':;:et. Another key to the success of the Korea Fund is the • favorable 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. 2.26 Other funds, however, have not been successful. A prime example is the Mexico Fund. Organized in 1981, the Mexico Fund's original share price at the time of issue was US$10. It now trades at between US$2 and US$2.70 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. 2.27 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. 2.28 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 inter national organization could also help establish the country fund in the underwriting and the investment in the fund, or both. - 31 Conclusion 2.29 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 finan cial sector reform in Argentina could include measures to facilitate some of these options and provide appropriate safeguards. - 32 III. DEBT-EQUITY SWAPS Background 3.1 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. 3.2 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 simplif,y portfolio administra tion. This was done without registering losses, even though the secondary market values were below par value. 3.3 Nationalization of Debt. Banks in many debtor countries had also participated as creditors in the debt run-up through their branches in off shore havens, the US, and Europe. Swapping arra~gements allowed private banks in debtor countries to concentrate their exposure in their own coun try. This portion of the country's external debt then becomes de facto domes tic loans. - 33 Debt-Equity Swaps 3.4 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 debt/equity schemes. 3.5 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, L.C. "Converting Soverign Debt into Equity Investment", International Financial Law Review, September 1986; Weinert, R.S. "Swapping Third World Debt", Foreign Policy, No. 65, Winter 1986/87; Larrain, F.B., "Market-Based Debt Reduction Schemes in Chile: A ..Ma~roeconomic Perspect.i.ve", The. World Bank CPD Dicussion Paper No. 19872, 'February 1987. .' 2/ For an illustration of transactions under Chile's debt conversion scheme, see Attachment 2. ' - 34 3.6 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? 3.7 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 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. 3.8 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. 3.9 Debtor Country. One cannot say categorically whether debt/equity 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 country's needs. A number of commentators have argued that debt/equity 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. . Possible Abuses # 3.10 There is also the possibility that the scheme may be used as a - 36 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. 3.11 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. 3.12 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- whether debt-equity swaps are a desirable way to address the problem. 3.13 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 - 37 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. Benefits/Subsidy 3.14 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-_ off'ioial exchange rate e.Let 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 "'f:"d Case B m,/ 0 Benefit element is d B in US$ + m Gross return d -,.;;;.... - d + m .' •• # - 38 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 0.43 (4:~: Case B Benefit is $25 Return is 0.36 (36%) Note that as the parallel and official rates diverge, the available benefit and the gross return are reduced. It is evident that debt-equity swaps would lose much of their attraction if the mark-up in the parallel market were close to the offered discount. The parallel rate is also a strong indicator of the perception that economic policy is (or is not) on track. Burden on Public Finances 3.15 In order to estimate the burden of debt-equity swaps on public finances, one must examine the particular circumstances. If it is not necessary for the Central Bank to issue offsetting domestic bonds to control liquidity, then the burden is reduced. But, this in turn would require that the fundamentals be in place; in other words, the fiscal deficit must be under control at an acceptably low level. This is not the situation in most debtor countries so that the reduction in external debt must be offset at least partially by a corresponding increase in domestic debt. The ratio of real domestic to foreign interest levels, id/if, .. gives a measure of the increased cost if the domestic debt is used to •• offset 100 percent • - 39 3.16 In the example quoted above, the change in annual interest costs I on a bond with face value US$B is given by: I = B (idjif - 1) $ equivalent 3.17 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. 3.18 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 3.19 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 . ",. .' - 40 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 Framework/Administration Procedures. If the scheme is to be attractive to foreign investors or help reverse capital flight, there must be a·consistent 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 any.pebt-equity swap • • to be accompanied by new capital inflow, this will modifY the attractiveness of such a scheme. - 41 Conclusion Debt-equity swaps are an interesting new development with advantages and disadvantages that depend on the particular country and the country"s 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. •• •• • ..-..". '.~ .. ,.,.,.,.., ... "''-' ,. " ca4PARABLE ACQUISITIONS IN THE SPECIALTY CHi4ICALS SrerOR IN THE U. S. PERIOD: 1977-1985 Multiples Net Income Book Value Sales High 73.7 6.2 1.8 Average 20.8 2.36 .96 Low 6.4 .8 .2 I +:' N I Value of Petroquimica Mosconi on a Comparable Acquisition Basis (U.S.$ Million) Net Income Book Value Sales High 5,700 1.534 246.0 MM Average 1,608 584 130.9 Low 495 198 21.0 '"d> III rt OQrt f1) III () Petroquimica Mosconi: Financial Data as of 12/31/85 ..... ::r o f1) s (U.S. $ Million) m::J rt 0'1 ..... Net Income $ 11.3 Book Value $241.4 Total Sales $136.4 5409j/l Attachment 1 Page 2 of 6 -43 . ~~ II . .]- ;;: J . .; ... ... .. .; ~i =, .. J'.", .. .. .. .. r.J Z.. .- • .:. - i Ii • ::i • "\ . .. .. i i • Ii i . 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! i. .. i, i •• • w Attachment 2 Page I of 6 -48 ILLUSTRATION OF TRANSACTIONS UNDER CHILE'S DEBT CONVERSION SCHEME This Annex describes the structure of 'typical' conversion transactions under Chapter XVIII and Chapter XIX of the Banco Central's 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 guaranteed.by 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 the 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 • • • Attachment 2 Page 2 of 6 -49 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). Trans.cCiOD 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 the:iocal 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 • ~ 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 (e.g.) U5$100.00 from a foreisn creditor ~ through his foreign agent for (e.g.) U5$70.00 and pays a commission of (e.g.) US$.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 te;ms ~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 -50 Step 6: The Chilean ~,with the prior agreement of the foreign creditor bank and the·Chilean debtor, redenominates the debt in local • currency ;qual to the face value of the foreign obligation converted at the official exchange rate (now Ps. 192) or for Ps. 19,200.00, 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 (e.g.) 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 (e.g.) 93 or Ps. 17,856 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. 201.00 is deducted for transaction costs, leaving net proceeds of Ps. 17,655 for investment • . Step 9: The equity shares or other evidence of the investment are delivered to the foreign investor. Financial Su..ary of the Debt Capita11.ation Tran.action (Valued in local currency at the parallel exchange rate) Por.tlD creditor bank -Holds debt obligation of US$100.00 which would have been paid at the official exchange rate. Local currency value: Ps. 19,200 -Receives payment of US$70.00 which has a value at the parallel exchange rate of: Ps. 14 z070 -Discount valued in local currency: Ps. 5,130 -Less Commission to foreign broker 201 -Value of the discount Ps. 4,929 Distribution of Value of the Discount Foreign Investor Paid to purchase debt: Ps. 14,070 Commission: 201 Ps. 14,271 Received for investment V Ps. 17 1 655 Investor's net gain Ps. 3,384 Domestic Broker commission Domestic financial"market discount • l01 1 z344 Ps. 4,929 2..1 See Step 8. Attachment 2 Page 4 of 6 -51 Foreign investor'. effective exchange rate Invests foreign exchange of U5$70.70. which otherwise would have yielded: Ps. 13,574.40 Official exchange rate:- 192 Through debt capitalization actually received in local currency: P51. 17,655.00 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. · Attachment 2 Page 5 of 6 -.JL Step 2: Once the foreign broker has located an appropriate debt investment, the Chilean investor obtains the agreement of the Chilean debtor to redenomin<ation 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 (e.g) US$70.00 and the price (i.e. 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, (e.g.) 15%. i r 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. 2,110:50 (15% of the authorized amount) an~ value added tax on the commission of Ps. 422.10 (20%). Step 6: The Chilean investor purchases the foreign debt obligation of (e.g.) USSLOO.QO from a foreign creditor ~ through his foreign broker for (e.g.) U3S70.00 and pays a commission of (e.g.) US$0.70 (1%). The p'Jrchased 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. 19,200.00, 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 (e.g.) 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 (e.g.) 93 or Ps. 17,856 which is delivered to the Chilean bank for disbursement to the Chilean investor. A commission of about U()"[1the face value or Ps. 201.00 is deducted for transaction costs, leaving net proceeds of Ps. 17,655. Attachment 2 Page 6 of 6 f 'f Step 10: The Chilean ~ reimburses itself for the commission paid to the Central Bank (Ps. 2,110.50) and the value added tax (Ps. 422.10) a~d pays the Chilean investor the balance of Ps. 15,122.40. Financial Su..ary of the Debt Conversion Transaction (Valued in local currency at the parallel exchange rate) Poreign Creditor bank -Holds debt obligation of US$100.00 which would have been paid at the'official exchange rate. Local currency value: Ps. 19,200 -Receives payment of US$70.00 which has a . value at the parallel exchange rate of: Ps • 14.070 -Discount valued in local currency: Ps. 5,130 -Less Commission to foreign broker 201 -Value of discount Ps. 4,929 Distribution of Value of Discount Chilean investor Paid to purchase debt Ps. 14,070 Plus commission Ps. 201 Ps. 14, 27 1.00 Net local currency received 11 Ps. 15.122.40 Net gain for Chilean investor 851.40 Central bank commission Ps. 2~ 110.50 Domestic~ker commission 201.00 Government value added tax 42.2.10 Domestic f1nancial market d1scount i.344.00 Ps~ 4,929.00 ~ See Steps 9 and 10. .. • Attachment Page 1 of .:. -')4 -LEGAL FRAMEWORK FOR DEBT CONVERSION IN CHILELl General 1.01 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 Chile's 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 1.02 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 e.g. terms affecting remittance rights.) Restrictions on remittance rights are limited to a 3 • year prohibition on capital transfers_from the date of investment. • Ll Source: World Bank, Debt Conversion. Chile Paper prepared by VPCAU, LEGVP, FPA. September 1986. Attachment 3 Page 2 of 4 -55 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 treatlLer.1: for the investment. The investor is assured of non-discriminatory treatment in legal and regulatory provisions affecting investment activities in Chile. 1.03 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 debtor's own capital. Chapter XIX 1.04 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. t Each investment conte.plated 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. Divi dends accumulated prior to such date may only be • remitted in 25% annual installments commencing the fifth year. • 1.05 The prin~ipal benefit to 4n investor coming in under Chapter XIX is that tt may purchase the original foretgn currency-denomi nated obligation at ~ discount (e.g. hecause the seller Ls Attachment 3 Page 3 of 4 -S6 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 J face value of the debt instrument and then utilize the peso holdings for such investments as it may wish • • Chapter XVIII 1.06 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 1.07 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 e.g. B-Loan B-IO, Sections 4.02 (b)(iii) and 5.11). 1.08 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 -57 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 "involur:.&ry new IIOney" calls) is is reduced or eliminated. l ! r r • " .