Mexico's external debt restructuring in 1989-90

Policy, Research, and External Affaire < s WORKING PAPERS Country Operations Latin America and the Caribbean Regional Offlice, Country Department 11 The World Bank June 1990 WPS 424 Mexico's External Debt Restructuring in 1989-90 Sweder van Wijnbergen Who in thie enid prof'ited miost fromi the official resources devoted to Mexico's last debt restructUring: Mlexico or its commercial creditors? Mexico. BuIt in establishing the basis for long-ternn growth thie package seemis a reasonable comipromilse betweenl thieconftlictinig interests of Mexico and its commercial creditors. [hne Po, I. X c,dn?,~ X! ~CrrdA .V'a, ~' Crxx lC;r k.tX %k-i An.g 'Npcm d,i,, o1s'!n,tcih.ec uvg a'd L t nora'c "C :~ .arI V-k ot1C41 11,r -4 l irevkeI inC .Cft';cvt, de IC KtI p'.Cnt S Cc. ',IsllX I>.sp;T Can C tre I' "' othe au~ rv , "ce, t -I ( I C. I 6' -''d ~'`'. * I '. Ve!A!! -~.'ing: l%':.v ngC :T:..'.a2i2,''' n'0  Policy, Researcl, and External Affairs Country Operations WFS 424 I his paper is a prodluct ol tlhc Country Operationis Division, Latin America and the Caribbean Re. onal Olfice, Country Department 11. Copies are available frec 1romm LtCe World Bank, 1818 If Sirect NW, Washinoton DC 2(A33. Please contact Margaret Stroude, roomI 18-1 63, extension 38831 (33 pages sK ith figures and tables plus 2I pagcs ot annex). Mexico's suspension ot ldebt service payments in w ho in thlc end proflitcd most Irom the ofticial August 1982 ushercdi in tlhc interniational debt resources devoted to the deal: Msexico or its crisis. In two consecutive debt rcstructurinri commercial creditors? He concludies: packages, in 1984 and 1987. Mexico bcgan vigorous structural rct'orm unider thc so-called Mlexico made elftficieint use ot tile official Baker plan. Miexico s cxpericence vividly f'undcs available lor debt reduction. Tlhc market denioiistrates the strength ofthat plan an; d tile value of' lth claims before enhancement dccli lcd reasons lor its cv cnualt Failure ---- thc fact thatl it by close to tile full amiloulit ot tthe value ofl the wlas inherently a short-term process. additional foreign ofticial resourccs devoted to thc packaec. TIhc rate ot rctuni on ltlc use on In December 19S8, Mcxico's Prcsidcnt offiicial resources far exceecis thie initerest rate at Salinas annriouniced that extenral creditor-s vcre \0hich dtei' %ere extcnide(l. 10 COnItribIte to a1 meIdiUml-IClI SOIlu- tion. In Marchi NS'). tte nc. tiL-.S. TreasUr TIhe market \aluc after errhan&'enient -k as SeCretar;\ Bdi'r , el ti'. civ l Citimi/ed th IIsicaiall the samt as the market \. alue ol th.e '.ord debt relicF in a sIpcchI thalt openle2d h the outltldlillng claims before the dCaIl so I.l 1or theI C I'9 (IC det re\trnctLri a1rl. erenlnt MC\I icos cornmicrciail cre(litors not at fiir dil . th1at \ a1 n Wi anaer. l ' !11cd\ /S hlere. 'I[lie crldit erdiallcellnclit b\ ain large :ii e ulp for thlc dieht relic. fil nlt) no eill t thlt tire Thatt anreeret.l oflfercd commerciil creditors oficiail cred(itors' mione\ hbenefited Me\ico the choic btxt \kcen exvehantnine old debt in,airu- rather tlan its commercial creditors. 'It'lc World mrct s for nce%' inistrumilents i' olv irli debt xrelict Bank, the IMF. and thte (Gocninlcnt of Ja'p,n do'. er inrtcrest rates or prillncipall b Nit a;lli'% ('AhInch pro'0\. ided tiIe official lrsoulrcs) aICii'.Ce(d seeLtrC d. ith coil a.eral: nr unsecurc( instrumrilits thlcir ohjevctivc of helping Mexico: theC additional itWOnLt debt rciiet. buit '.t it a ev. nio11ton re sourc (sldid tIt aiccrue to the creditors, 'i. rich omilillitmlielnt tlliltlcd. man'. feared and soImeC (iccme(d inevitalhc. .z\ctve idehates o tire rlcer;ts ol thiis packae lhail . oil the blasis ol availab!le ct.\ idice. reV oftell Confused.na Ill Lill C\tCnsiVC CCOnollic this pCke cstablishcidlIc haksis tor sustairabie nalsi si .Lin \Wijrrbrergen addrcsses tife Luestionl: _ ro'.tf iii Mlc\ico. ! i I'8i' 0!' 4eii: 'A l'.,ir L!:a's ' .1 A tilt: iX. Pk'11 !! .11 Ti:. 1:" > , ; ; . !. ," .; ); ; )- !.O t:.:'IT! '!! ni1r .s1l : 13 WJ 1il.ll':1'  Mexico's External Debt Restructuring in 1989-90 Sweder van Wijnbergen I am indebted above all to my colleagues in the World Bank'- Latin America Vice Presidency and the Mexico Division of the IMF for many helpful discussions and comments. I have furthermore benefited from disn.ussions with Augustin Carstens, Stijn Claessens, Daniel Cohen, Manuel Galan, Reuben Lamdany, Ricardo Martin, Sergio Pena and Luis Tellez. Much of the work presented here is based on joint work with Sergio Pena and with Stijn Claessens.  I INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 II ECONOMIC BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . 3 II.1 Macroeconomic Developments . . . . . . . . . . . . . . . . . 3 A. The Period Leading Up to the Scabilization Program 88/89 . . . . . . . i . . . . . . . . . . . . . . . . . 3 B. Macroeconomic Stabilization . . . . . . . . . . . . . . 4 II.2 The Process of Structural Reform . . . . . . . . . . . . . . 5 A. Rationalized Private Sector Incentives . . . . . . . . 5 B. Reorientation of Public Spending . . . . . . . . . . . 5 II.3 The Case for Debt Relief . . . . . . . . . . . . . . . . . . 6 III THE DEBT AGREEMENT BETWEEN MEXICO AND THE COMMERCIAL BAIKS . . . . 7 III.1 Structure of the Debt and Pre-Deal Financing Gap. 7 A Structure of the Debt . . . . . . . . . . . . . . . . . 7 B. Financing Requirements and Financing Plan 1989-94 . . . 8 III.2 Economic Considerations Underlying the Package . . . . . . . 10 III.3 Negotiating Mexico's External Debt: a Brief Chronology of Events . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 III.4 Terms of the Agreement . . . . . . . . . . . . . . . . . . . 13 A Debt and Debt Service Reduction Options . . . . . . . . 13 B New Money Options . . . . . . . . . . . . . . . . . . . 14 C Debt-Equity Conversion . . . . . . . . . . . . . . . 16 D Recapture Clause . . . . . . . . . . . . . . . . . . . 16 E Credit Enhancement . . . . . . . . . . . . . . . . . . 16 III.5 Subscription by the Commercial Banks . . . . . . . . . . . . 19 IV EVALUATION OF THE AGREEMENT: DEBT RELIEF . . . . . . . . . . . . . 21 IV.1 How much Debt Relief? . . . . . . . . . . . . . . . . . . . . 21 IV.2 Is there Enough Debt Relief? Rate of Return Approach . . . . 22 V IS THERE ENOUGH DEBT RELIEF? MARKET EVALUATION . . . . . . . . . . 23 V.1 Market Valuation of the New Instruments . . . . . . . . . . . 23 V.2 Market Valuation of the Debt Package: Did Mexico Strike a Good Bargain? . . . . . . . . . . . . . . . . . . . . . . . . 25 VI IMPACT OF THE DEAL ON THE FINANCING GAP, CREDITWORTHINESS AND GROWTH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 VI.1 Impact on Financing Gap and Creditworthiness indicators . . 26 VI.2 Impact on Economic Growth . . . . . . . . . . . . . . . . . . 28 VII CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 REFERENCES ..32 ANNEXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 I GROWTH. DEBT RELIEF AND THE REAL EXCHANGE RATE IN MEXICO . . . . . 2 II SECONDARY MARKET PRICING AND THE VALUATION OF THE RECAPTURE CLAUSE: AN OPTION PRICING APPROACH . . . . . . . . . . . . . 12 III CHOICES MADE BY MEXICO'S CREDITORS . . . . . . . . . . . . . . . . 21  1. I INTRODUCTION Mexico has throughout the eighties been at centerstage in the debates and events shaping the sovereign debt problem. Caught between a sudden collapse of its terms of trade and rising world interest rates, Mexico's suspernsion of debt service payments in August 1982 ushered in what has since become known as the debt crisis. In the years that followed, it became the de facto paragon of the approach of Mr. Baker, at the time the US Treasury secretary, to th. debt crisis; after initial retrenchment and consolidation, Mexico started a vigorous process of structural reform, relying on international capital markets to support that process through rescheduling and new money in two consecutive debt restructuring packages (83/84 and 86/87). Mexico's experience over those years vividly demonstrates the strength of that approach; but equally clearly on display are the reasons for the eventual failure of the Baker plan. While the reform process promised tangible benefits over the medium term. reschedulings and new money commitments came on a short term basis only, and each time after tortuous negotiations. This inherently short term process left continuing uncertainty as to whether similar accommodation would be available two three years down the road. It thus failed to provide a medium term framework within which the private sector could, with reasonable confidence, assume current policies to continue. The resulting uncertainty about exchange r tea, future tax policy and financial regulation ruled out a return of flight capital and the recovery of private investment. As a consequence growth stagnated to such an extent that the social consensus behind the reform program came under increasing stress. Towards the end of the de la Madrid administration, the view took hold that a different approach had to be taken. Th:.s view was pursued with vigor by tho Salinas administration that took power in 1988 (and by and large carried over the economic team from the previous administration). On the one hand, the reform process was accelerated beyond anybody's expectations, and a comprehensive, imaginative macroeconomic stabilization program skillfully put in place. On the other hand, President Salinas, in his inauguration speech on December 1, 1988, gave external creditors notice that, while Mexico wished to avoid confrontation, they were expected to contribute to a medium term solution of Mexico's debt problem. At about the same time, the main international organizations took a considerably more flexible approach to debt management in their annual meeting in Berlin, September 1988. But the real breakthrough came when Brady, Baker's successor as Secretary of the Treasury in the US, in a speech at the State Department March 10, 1989, effectively legitimized the word debt relief. This speech opened the way for the negotiations between Mexico and its commercial creditors that, six months later, led to the agreement that is the subject of this paper. The agreement reached on July 23, 1989 offered commercial creditors the choice to exchange old debt instruments for new instruments invalving debt relief (lower interest rates or lower principal), but partially secured with collateral; or for unsecured instruments without debt relief, but with a new money commitment attached. Significantly, the option to just retain the old instruments at unchanged terms was not left open to any commercial creditor. An active debate has since begun on the merits of this package, a debate that, unfortunately, is often marred by basic confusion about and misunderstanding of both the facts and likely economic corsequences of the agreement reached.  2 It thus seams an opportune moment to provide both a detailed description of the package and a comprehensive economic analysis. Section II outlines the main course of economic developuaits in Mexico leading up to the agreement. A full understanding of this economic background is essential for an understanding of the urgency with which Mexico and its supporters in the international community approached the negotiaticns. Section III then outlines the structure of Mexico's external debt and its financing needs anticipated at the outset of the negotiations. This section also provides an overview of the economic considerations underlying :he structure of the agreement finally reached, and a detailed description of that agreement. Sections IV-VI then provide detailed economic analysis. Set-Lon IV first assesses the amount of debt relief, and asks the question whether th's amount of debt relief represents a good return on the resources devoted to the deal. The paper then takes the point of view of Mexico's creditors and, in Section V, provides an assessment of the market value of all outstanding coumercial claims on Mexico before and after the deal, and with and without the official credit enhancements provided, by third parties and by Mexico itself, to creditors choosing one of the debt relief options. The question addressed here is, who in the end profited most from the official resources devoted to the deal, Mexico or its commercial creditors? This question cannot reall-y e answered by simply reading off secondary market quotations of the various nstruments traded before and after the deal. International events did not staud still over the six months of the negotiations, and it is thus difficult to disentangle the impact of the deal from other events influencing market evaluation of Mexico's credit risk. To separate out the impact of the deal, a formal framework is used based on financial option pricing techniques (see Claessens and van Wijnbergen (1989) and Annex I to this paper). Section VI looks at what is arguably the most important aspect of the deal, its likely impact on the recovery of economic growth in Mexico. The section first assesses the impact of the deal on Mexico's financing gap. It then uses a quantitative framework dev.loped for this purpose (cf van Wijnbergen (1989, 1990b) and Annex II to this paper) to assess the likely impact of the deal on Mexico's prospects for a recovery of economic growth. Section VII draws all the threads together in a conclusion, making three points. First, Mexico made very efficient uses of the official funds available to it for debt reduction purposes. The market value of the claims before enhancement went down by close to the full amount of the value of the additional foreign official resources devoted to this package. On a different measure, the rate of return on the use of the official resources far exceeds the interest rate at which they have been extended. Second, although it follows by implication from the first observation, the market value after enhancement was basically the same as the market value of the outstanding claims before the deal. Mexico's commercial creditors thus got a fair deal, with the credit enhancement by and large making up for the debt relief granted, but not more than that. Thus, the official creditors' money ir the end mostly benefited Mexico rather than its commercial creditors. Therefore, the World Bank, the IMF and the Government of Japan (who provided the official resources contributed to this deal) achieved their objective of helping Mexico; the additional resources did n accrue to the creditors, something that was widely feared in advance, and has been claimed as unavoidable by  3 some. Third and most importantly, on the available evidence this package seems sufficient to establish a basis for ustainable growth in Mexico. II ECONOMIC BACKGROUND In the years preceding the 1989/1990 debt negotiations, Mexico has gone through a rather tumultuous series of macroeco,.omic developments, and, towards the end, through an increasingly rapid process of structural reform. A better understanding of what happened in the years leading up to the negotiations explains much of the various parties negotiating positions, and of the urgency behind the proceedings. We therefore provide a brief survey of this period.21 II.1 Macroeconomic Developments A. The Period Leading Up to the Stabilization Program 88/89 Between 1950 and 1974, Mexico enjoyed a remarkable period of high growth, low inflation and moderate external debt accumulation. Real growth averaged 6.4%, and inflation was in single digits throughout the period, in line with the prudent fiscal policies followed. This era of fiscal conservatism came to an abrupt end in the early seventies. Government involvement in the economy expanded rapidly, and increased public expenditure pushed up aggregate demand and the rate of economic growth. However, the higher government expenditure was not matched by rising public sector revenues. As a result, the inflation tax and external debt became increasingly important sources of public finance. At the same time, a decline in private savings incentives (real interest rates turned sharply downward) prevented a matching increase in private savings; external debt thun increased, increased oil revenues notwithstanding. The period of single digit inflation ended in 1973, the real exchange rate2l started to appreciate and the accumulation of external debt accelerated above the GNP growth rate. A serious, but comparatively brief, financial and economic crisis in 1976 terminated following major oil discoveries in 1977. The ensuing prosperity lasted until 1982, when soaring domestic inflation, falling international oil prices, rising world interest rates, and massive capital flight led to a refusal bv external creditors to roll over Mexico's short-term debt and a subsequent suspension of Mexican payments of interest on its external debt. Over the 1982-88 period, economic growth ground to a virtual halt. This was accompanied by charply falling living standards, a deteriorating infrastructure, high inflation, and a loss of investor confidence. Towards the second half of t.his period, a series of measures was taken to reverse Mexico's declining fortunes. Among the most important goals were: (a) macroeconomic stability; (b) a rationalized set of incentives for private sector investment; (c) reallocation of public spending to support private sector-led growth, improved social services and the environment; and (d) a J/ A more detailed treatment can be found in Dornbusch (1988), Ortiz (1990) and van Wijnbergen (1989). 2/. The real exchange rate is defined as the price of foreign goods relative to domestic goods. Appreciation means a decline in this relative price.  4 credible financing plan to renove the unsustainable uverhang of external debt. In each of these areas, the Ltxxican Government has achieved notable progress. B. Macroeconomic Stabilization The onset of the financial and economic crisis of 1982 brought in its wake explosive inflationary and balance of payments difficulties. Initial strong fiscal and monetary adjustment efforts were alternately not sustained for a sufficiently long period (1983-85) or undermined by external shocks such as the collapse in international oil prices (1986). Inflation, rather than slowing down, accelerated, partially in response to the sharp real devaluation of the excharge rate necessitated by the 1986 downturn in the terms of trade. The subsequent de facto targeting of the real exchange rate, together with an increase in the frequency of wage and cost adjustments, introduced an element of inherent instability into the system, culminating in a run on the peso in the last quarter of 1987 and triple-digit inflation. The Government responded with the "Economic Solidarity Pact" (Pacto), an agreement between business, labor, and government. This agreement called for accelerated structural reform, further tightening of fiscal and monetary policy, a freeze of minimum wages and of basic public and private sector prices, and, the cornerstone of the "Pacto", a freeze of the nominal exchange rate against the U.S. dollar. This partial freeze was extended at three- month intervals through the end of 1988, and renewed, with some modifications, by the new Mexican Administration under the name of "PECE" (Pact fo' Stabilization and Growth) through July 1990. The main adjustments brought about under the PECE initially were once-off catch up increases in selected public sector tariffs and in prices of key inputs, a two-stage 26% cumulative adjustment in the minimum wage, and a daily adjustment of the exchange rate of about one peso against the U.S. dollar. More recently, it has been announced that public sector prices will be adjusted more re 1.arly but by smaller amounts, in line with general inflation targets. I. 1dition, there has been substantial progress towards more flexible pricing, most recently in agriculture, The current policy stance is thus more flexible and more in line with current actual inflation than it was one year ago; arguably the PECE's "soft landing" has almost been achieved. The fiscal measures, backed by the temporary exchange rate freeze and an array of formal and informal wage and price controls, have had a dramatic success in reducing the rate of inflation, from 159% in 1987 to 20% itl 1989, a rate that will likely also obtain in 1990. At the same time, the economy has shown encouraging signs of economic recovery, led by a strong resurgence of privatoi investment. Industrial production wds 6% higher in the first half of 1989 than in the same period a year earlier, and the economy has grown by an estimated 3% in real terms for the year as a whole. The current account balance has deteriorated from a 1988 deficit of US$3 billion to an estimated deficit of more than US$5 billion in 1989. This is largely due to the acceleration in private sector investment and a drought-induced decline in net agricultural exports which has brought about a temporary decline in income. Manufactured export growth continues at an annual rate of about 10%, less than in 87/88 as the real exchange rate appreciated somewhat over the pacto period, in which the Peso was kept fixed against the dollar. Interest rates, although still high by historical standards, declined by about 20 percentage points within days after the announcement in July 1989 of a debt reduction  5 agreement between Mexico and its-commercial bank creditors. The same factors have also led to more than US$2 billion in returned flight capital in 1989. II.2 The Process of Structural Reform A. Rationalized Private Sector Incentives Mexico has, since 1985, transformed itself into one of the most open economies in the world through an extensive trade reform. Trade liberalization to date has lowered the oercentage of domestic (non-oli) tradeoDle production covered by import quotas from 100% in 1984 to less than 17% at present. Maximum import tariffs were cut by similar magnituaes, from over 100% down to 20%. Non-oil merchandise exports, which represented less than one-third of total exports in 1984, have doubled their share since then, These "core" reforms have been complemented by ma.ny others. Recognizing that the era of public sector-led growth had passed, the Government took a number of measures to stimulate greater private investment. In May 1989, foreign investment regulations were considerably relaxed and made more transparent. A long-standing prohibition against majority foreign ownership was removed, the fishing, petrochemical, and mining sectors were oper.ed to foreign investors for the first time, the licensing of proposed investments under US$100 million was made automatic in those sectors, and approval of larger investments bec3me automatic following a 45-day waiting period, unless the Government interposed formal objection within that waiting period. Since 1986, the tax system underwent a series of reforms bringing marginal tax rates more in line with levels in major industrial countries, encouraging the repatriation of flight capital, and increasing the sanctions for tax evasion. Also, profits are for tax purposes now adjusted for the effects of inflation on assets and liabilities, and the previous bias against equity finance has been reduced substantially. To encourage improved mobilization of domestic savings, the Government initiated a parallel process of financial market liberalization, supporLed by a Financial Sector Adjustmeat Loan from the Bank. Commercial banks no longer face any ceilings on the deposit interest rates they can charge; .he system or forced allocation of commercial credit towards favored sectors has been abolished and credit subsidies through official deve.opment banks have been reduced significantly. The principal development and agricultural banks in the public sector are in the midst of significant managerial and financial restructuring, designed to consolidate institutions, clean up balance sheets, and reform lending practices. To reduce the role of the public sector in production, over 750 state- owned enterprises were sold, transferred, or liquidated between 1)83 and the present. Many large-scale enterprises underwent major financial and partial managerial restructurings. More recently, the Government announced 'lans to sell the country'3 largest airline and its telecommtnications company. It also placed in receivership for eventual sale or liquidation the country's largest mine. A radical deregulation of the transport sector has already been implemented. Such deregulation is useful in its own right, but it also increases the efficiency gains from the trade reforms uriertaken earlier. B. Reorientation of Public SpendinLg  6 Since 1982, a major retrenchment of public expenditure has taken place. Non-interest spending declined from 35% of GDP in 1981 to around 20% in 88/89. The composition of the cutbacks was, pethaps, not ideal from the standpoint of growth. Real investment expenditures were cut more deeply than current outlays, posing the risk, now that growth is underway once again, that infrastructural bottlenecks might impose constraints on potential growth. Also, some of the gains in reducing illiteracy, infant mortality, and nutrition during the seventies are threatened by the sharp cutbacks in public expenditvres for social programs. The social sector's budgetary share declined from 20% or imore in the years preceding the 1962 to around 13% currently. This trend is probably unsustainable, given the worsening inter- personal and inter-regional income disparities. In recent years, authorities have sought to soften the blow of reductions in social expenditures. Global consumer subsidies for basic food items are being replaced by less expensive, but more targeted, subsidies to the poor. In 1989, a new "National Solidarity Program" has set aside US$400 million to coordinate the activities of existing agencies and provide limited additional budgetary support for agriculture, infrastruc'ure, and social programs in Mexico's ten poorest states. For example, title to 100,000 urben plots is to be regularized, 150,000 hectares of semi-arid arable land rehaoilitated, and tubewells, irrigation works, and rural infrastructure extended. And, starting in June 1989, a program to rehabilitate 25,000 primary and secondary schools began, with an expected cost of nearly US$220 million. Given the severe fiscal constraints, the need to rebuild crumbling roads, bridges, and other infrastructure is at present only partially met. Resources are found by shifting public expenditure away from activities which could be better carried out by the private sector, such as steel, mining or telecommunications, to areas like transport infrastructure where the state's role is more easily justified. However, the restoration of sustainable growth will require a gradual increase in public investment over the next few years, for agriculture, the eTivironxment, transportation, energy, and the social sectors, II.3 The Case for Debt Relief Despite the far reaching reforms implemented in Mexico, international capital markets have not provided the resources needed to bridge the period between the current costs and the future benefits of the reform program. Continuing high external transfers generated uncertainty about whether the rapidly growing transfer burden could be met. This, in turn, generated increased uncertainty about future exchange rates, taxation, and financial regulation. Thus, to forestall further capital flight, Mexico had to pay unsustainable interest rates on its domestic debt. "Ex post" real interest rates were almost 50% in the weeks before the debt accord was reached. Real in-erest rates so far above the real growth rate of the economy are explosive under any circumstance; however in Mexico there is an additional complication in that the government is in the middle of a stringent economic stabilization program in which fiscal retrenchme:ut plays an important role. However at a 30% real interest rate (the average level for most of 1989), the current fiscal stance is far out of line with the stated inflation target of 18-20 percent. The reason is that, at 30% real interest rates on domestic.  7 debt, the government needs mole than 6% of GDP in extra revenues for domestic debt service alona. The uncertainty caused by future transfer problems, through its impact on domestic real interest rates, war thus a direct threat to the survival of the still highly successful stabilization program. Therefore the beneficial domestic effects of the aebt: package will follow as much from reduced uncertainty and improved expectations about future policies as from the direct fiscal impact of any reduction in net transfers to foreigners. But for such expectational factors to come into play, the deal really needs to be of a medium term nacure. Hence the imperative not only of a solution, but a solution that would likely forestall debt problems for the foreseeable future. Against the background sketched so far, Mexico initiated the debt negotiations to seek international sur -rt for its far-reaching Ltjustment program and recovery of economic growth. The Government has already demonstrated its strong commitment to the program, but its continued success depends on tne availability of external support. Because of the high domestic costs of continuing uncertainty, the required international support can make a substantial difference only if it is basee on an unequivocal, medium term commitment by the creditors. Therefore, Mexico has pressed in the negotiations for a multi-year financing package. The need for debt relief, in the case of Mexico, needs to be seen from this perspective. It was not so much the level of the country's debt, but the current flow of debt service payments that is too high, and causes too much uncertainty to allow growth and sustainability of adjustment. The need for debt relief has to be seen in this context. Debt reli3f offers the most certain way to reduce future net transfers for a long time to come. However new money commitments, if credible and stretched out far enough into the future, could have served equally well. There are otl.er arguments, however, both political and economic, that stress the importance of debt relief over new money commitments. Political because Mexicans have made such enormous adjustments, accepted such a large reduction in living standards, that any package without an extensive and visible contribution by external creditors would not be acceptable domestically. Economic because the new money commitments, while generous, stretch out for three and a half years only, possibly not enough to see a process of economic growth firmly established. The conclusion should be clear. Mexico had the structural policies and domestic fiscal measures in place for sustainable growth to take off. What was missing was a sufficiently long period during which external creditors would allow this inherently sound economic program t -et off the ground. The only way of obtaining a credible commitment to such medium term international accommodation is debt relief. III THE DEBT AGREEMENT BETWEEN MEXICO AND THE COMk4ERCIAL BANKS III.1 Structure of the Debt and Pre-Deal Financing Gap A Structure of the Debt At the end of 1988, Mexico's external debt was at $100.4 billion. Of this total, most is held by commercial cieditors (see Table 1), with the remainder held by official creditors. Among official creditors, the Bank  8 holds $7.4 billion and the IMF $5 billion. Of the commercially held debt ($70.6 billion), a smtll amount ($5.1 billion) has never been rescheduled. The bulk of this $5.1 billion consists of PEMEX liabilities ($3 billion) that traditionally have been rolled over automatically. Table 1: MEXICO: EXTERNAL DEBT BY CREDITOR AS OF END OF 1988 (USS billion) Commercial banks: 70.6 of which to: Public Sector 65.1 of which: Rescheduled 3/.9 Now Money 14.8 non-rescheduled 5.1 Inter-Bank 7.3 PrLvate Sector 5.5 Other Creditors: 29.8 of which to: Public Sector 28.8 of which IBRD 7.4 IMF 5.0 Bilaterals 8.7 Bonds 3.7 Others 4.v Private Sector 1.0 TOTAL 100.4 The new financing package covers the sum of the $37.9 billion that was rescheduled during 1986/1987 and the $14.8 billion of new money that was provided in the previous two rescheduling exercises (1983/1984 and 1986/1987). This total ($52.7 ui.llion) has since been reduced to $48.9 billion because of cross-curren..y exchange rate changes, debt-equity swaps and cancellation of debt held by Mexican institutions. Thus the basis covered by the debt package is $48.4 billion. A certain amount of sovereign debt is held by Mexican owned banks. Those claims will either be brought under the new nioney option described below, or will not receive enhancements if debt or debt service reduction options are chosen. B. Financing Requirements and Financing Plan 1989-94 Based on simulations with the model presented in Annex I, Mexico's total gross financing needs over the 1989-1994 were estimated to amount to over $50 billion (Table 2), This level of financing would accommodate a growth target of an average 4% over the next six years, provided, however, that the non- interest current account would generate a surplus of 2.4% of GDP on average. At current interest rates and for the given structure of the country's debt, this leads to a cumulative current account deficit of around $23 billion (around 1.5 percent of GDP on average). In addition, reserves were assumed to  9 increase by $3.1 billion, a, tipulated under the IMF Extended Fund Facility that came into operation May 1989, raising the total to around $26 billion. Total finanning requirements include, in addition, the scheduled net amortization payments to commercial banks, bondholders, suppliers and holders of private t,on-guaranteea debt. These amortization payments were estimated at US$18.3 billion over the same period. Table 2: MEXICO'S FINIANCING NEEDS AND SOURCES 1989-1994 (bUSS) Needs Sources Current Account deficits Direct Foreign Investment 21.9 and reserve chang.s : 26.2 International Financial Instituttions 3.4 Net Scheduled Amort.: 18.3 of which: of whic'i to: IBRD: 4.93/ Comm. Banks 12.7 IMF :-1.33/ Bonds 1.2 Bilaterals 2.3 Priv.Non- ------------------------------------ Guar.Debt 4.3 .ibtotal 27.6 Suppliers 0.1 Other Capital Outflow 6.52/ FINANCING GAP 23.5 Total 51.1 Total 51.1 Notes: 1/ Totals may not add up due to rounding error. 2/ "Other Capitel Outflows" is the bookkeeping counterpart to the current account item "imputed interest enrnings on private assets held abroad." 3/ This does not include additional disburbements of US$ 950 million and US$ 600 million under the Interest Support Facilities of respectively the Bank and the IMF. To meet the above needs, funding is expected to be available from net lending by bilaterals and the international financial institutions. In addition, substantial direct foreign investment (DFI) is projected to take place in response to the economic reforms described in the preceding Section, including the recent liberalization of the foreign investment regime. However, Table 2 indicates that funds available from these sources were short of gross financing needs; thus a financing gap was projected of $23.5 billion cumulatively over the period ending in 1994, or almost $4 billion per year. This includes amortization on commercially held debt ($12.7 billion). Therefore, the corresponding net financing required from debt service reduction, new money and return of Mexican flight capital would have to be $10.8 billion. This scenario is sensitive to developments in the world environment. Every dollar decrease in world prices for Mexican oil costs Mexico $0.5 billion in foregone export revenues per annum. Thus if oil prices are two dollars lower than assumed, Mexico would lose up to $6.0 billion over six  10 years.21 The financing gap would increase correspondingly. Of course unanticipated increases in the price of oil would reduce the financing gap. Similarly, a one percentage point increase in international jnterest rates would increase the cumulative current account deficit by close to $6 billion over the period, with a matching increase in the financing gap. This sensitivity to international interest rates highlights the potential benefits of fixed interest debt instruments. III.2 Economic Considerations Underlving the Package Al From the Mexican point of view, two considerations were important in judging any proposal: impact on cash flow and implied debt relief. On the one extreme, rescheduling, capitalization of interest due and new money have a one for one positive impact on cash flow but imply no debt relief. On the other extreme are reserve financed debt buy-backs in the secondary market: these imply debt relief equal to the amount of debt repurchased times the discount at which it is bought, but actually lead to negative cash flow effects in the year of purchase. An alternative way of looking at cash flow effects is, to recognise that Mexico because of the external credit constraints, must have a higher discount rate than suggested by world interest rates. In that case, packages with equal discounted value when evaluated at world interest rates may have a different discounted value when evaluated at the Mexican, higher discount rate. In particular, packages that give the debt relief early on would be preferred on that criterion. Thus, a reserve based debt buy back would be worse than an equal present value (evaluated at world interest rates) cut in interest rates when evaluated at Mexican discount rates because of the early negative cash flow effect of such buy backs. The impact of Central Bank reserve losses on the precarious exchange rate situation made reserve financed debt buy-backs ill advised. Any package thus had to come down to a combination of cash-flow oriented interest- capitalization/new-money schemes and debt-relief oriented debt exchanges. For similar reasons, debt reschedulings with relending provisions, like those incorporated in Brazil's package in 1988, were not advisable on a significant scale. In an economy with open capital markets like Mexico, a relending provision is tantamount to instantaneous prepayment at face value. Such an arrangements would thus not only involve no debt relief, but would also result in a major negative cash flow impact. The only way to avoid this is to restrict on-lending to public sector agencies. Debt buy-backs can be distinguished by the asset being sold (or type of new debt issued) to finance the debt buy-backs. These could be publicly owned assets; examples are a reserve financed debt-buy back or debt equity swap involving a parastatal. When such schemes involve public assets, there are no fiscal problems since the public sector already owns the asset. ii Oil export volumes are projected to remain constant for the next six years. The oil prices mentioned refer to the average price of Mexico's oil exports. Recently, this price has stayed about $3.50 US$ below the price for West-Texas Intermediate. A/ This Section draws on Pena and van Wijnbergen (1989).  11 The case of public debt for private assets (for example equity) is different: to execute such a public debt for private equity scheme, the public sector needs to acquire the asset first. Therefore, the government needs to raise the resources to acquire the private asset. For the evaluation of such public-debt/private-equity swaps it matters how the government raises the resources to acquire the private sector asset. This can be done through increasing the primary budget surplus, inflation tax, internal debt iss.:e o external (net) debt increase (i.e., reserve losses). The primary surplus is already strained to the limit as part of the current fiscal ietrenchment. Use of the inflation tax (through a change in exchange rate policy) goes against the grain of the current stabilization program. Use of internal debt issue is ill advised as long as internal debt carries in excess of 30 percent real interest rates. Finally, we already mentioned that the use of reserves is not possible in the current precarious exchange rate situation. These considerations ruled out public debt for private equity swaps. Anyhow, Mexico's experience in the 1987 program suggests that such schemes reduce debt but not really foreign liabilities: the average discount was slightly over 10 percent only (Sanguines (1989)). One could conceivably use the privatization program to engineer public debt for public equity swaps, but unless claims on future oil production are brought in, such schemes sill never be big enough to have a major impact. Thus, while debt-equity swaps might play a small positive role in the government's privatization program, they cannot and should not play a major role in any debt reduction operation. That left as the only option exit bond schemes and cash flow oriented measures. Exit bond schemes would require guarantees of principal and interest payments to allow significant debt relief. But any package also had to involve major cash flow oriented measures, such as for example interest capitalization. An attractive option was reduced interest rates. Refinancing of old loans at lower 'nterest rates implies debt relief because the discounted value of all future payment obligations falls; at the same time it provides early cash flow relief because it does not involve any purchase of assets up front. Finally, since there is no need for the public sector to obtain ownership of private assets, no fiscal problems arise. Thus interest relief combines the favorable cashflow effects of new money packages with the debt relief impact of discounted exchange offers. But to maximize the amount of debt relief, there was no doubt Mexico had to offer its creditors a menu of choices. The reason why a single option deal would have reduced the amount of debt relief lies in the differences in regulatory and tax environment that Mexico's various commercial creditors face. For this reason, different schemes that would present equal debt relief to Mexico, could implie very different costs to its creditors. Thus, restricting the choice to one instrument only would, for given willingness to grant relief by the creditors, unambiguously reduce the amount of relief actually received by Mexico. Finally, for maximum impact on credibility of the stabilization effort and hence on domestic interest rates, the more years are covered by any deal, the better: year to year deals keep the possibility of impending BoP crises open. A deal for the first three years would, unless accompanied by some sort of an understanding on what will be done beyond 1991, cast a large shadow over Mexico's adjustment program.  12 This is in particular an issue for the revival of private investment, because of the irreversible nature of capital accumulation. Uncertainty about the future will bias private savers towards more liquid assets, including foreign ones, until such uncertainty is resolved. Also, with the possibility of BoP crises still looming at the horizon, a major reduction in domestic real rates would seem unlikely: nominal rates would first of all reflect higher expected depreciation, raising "ex post" real rates; second, private investors would almost ceitainly require continued high premiums before they are willing to bear exchange rate risk, raising "ex ante" real rates too. This suggests that a shor.-term deal will not only preclude a recovery of private investment, but it will also perpetuate the current fiscal problems created by high real interest rates on domestic debt. III.3 Negotiatinz Mexico's External Debt: a Brief Chronologv of Events Negotiations were extraordinarily complicated straight from the beginning. One complicating factor was the number of banks involved (more than 600). This problem was dealt with in what is by now a standard solution, through the formation of a Bank Advisory Committee with representatives of some 15 creditor banks. This committee conducted the actual negotiations with representatives of the Mexican Government, which were concluded with the July 23 agreement on a "term sheet" containing the outlines of the agreement. But there were more players in the act. Prior to any negotiations with commercial creditors, Mexico sought to reduce net external transfers to its official creditors, and in addition, sought their support for the principles underlying subsequent negotiations with commercial creditors. An agreement was reached with the Paris club covering $2.6 billion of principal and interest payments falling due in the period 6/89-5/92. All amortization over the three year period was rescheduled over ten years with 6 years grace. Also rescheduled were 100% of interest payments due in the first year, 90% of interest payments in the second, and 80% of interest due in the third. Access to import financing of up to $2 billion per annum was also secured. Even before this agreement, negotiatons had started with both the World Bank and the IMF about a major package of support measures. In February 89, Mexico and the IMF reached agreement on an Extended Fund Facility for SDR 2.9 billion (about $4.1 billion) covering three years and an optional fourth one. At around the same time, the World Bank and Mexico successfully concluded extensive negotiations covering three Structural Adjustment Loans for $0.5 billion each, plus a commitment by the World Bank to a lending program of about $2 billion per year for the period 1990-1992. Moreover, both institutions publicly supported Mexico's claim that reduction in Mexico's debt burden was called for in one form or another if growth was to recover in Mexico. In a historically unprecedented move, both the IMF and the World Bank allowed a portion of the resources extended to Mexico to be used for support of debt reduction operations ("Set Asides"). In another first, both institutions made available to Mexico an additional, one- time sum for debt reduction purposes (Interest Support Facilities of $0.6 billion from the IMF and $1.26 billion from the World Bank). At the same time, the Government of Japan, through its EXIM bank, offered financial support to Mexico to the extent of $2.05 billion, also to be utilized in the debt reduction package with the commercial banks.  13 Once negotiations with the IMF and the World Bank were concluded, negotiations with the Bank Advisory Committee began in New York early April. Although tha negotiations were officially behind closed doors, the various proposals and counterproposals were widely reported in the press throughout the three months of negotiations. The initial skirmishing was about Mexico's financing needs were growth to recover, in which both the World Bank and the IMF played an advisory role, albeit an unofficial one. When the negotiations moved on to debt relief, initial positions were far apart, with Mexico asking for 55% debt relief and the committee offering only 15%. Although various counterproposals brought the parties somewhat closer, negotiations in New York seemed to stall beginning of summer and wer. escalated towards a higher level. The final negotiations, in Washington DC, involved Secretary Brady, the chairmen of the most important banks i.&.volved, senior officials of the World Bank and the IMF and, from the Mexican side, finance minister Mr. Aspe and debt negotiator Curia. This phase was successfully concluded with the announcement of an agreement in principle on July 23, 1989. This agreement included a debt relief option involving 35% debt relief, exactly halfway the opening proposals of both parties. The structure of this agreement, which was further refined in subsequent negotiations between Mexico and its commercial creditors, is described in the next section. II1.4 Terms of the Agreement On September 15, l989, the Government of Mexico and the Bank Advisory Committee representing the commercial bank creditors reached agreement on a financing package covering the period 1989-92, restructuring approximately US$48.4 billion of Mexico's external debt. The agreement consists of a menu of financing options which includes two debt and debt service reduct'.on facilities and four new money facilities. On the same day, the Government of Mexico disseminated a term sheet to all of its commercial bank creditors and invited them to participate in the financing operation. The following are the summary terms of the financing options offered by Mexico to its commercial bank creditors under the 1989-92 Financing Package: A Debt and Debt Service Reduction Options Option A: Collateralized Floating Rate Discount Bond Exchange. Creditors may exchange eligible debt for new collateralized floating rate discount bonds issued by the United Mexican States in a principal amount equal to 65% of the principal amount of the eligible debt offered for exchange. The new bonds will be in registered form, will mature ih a single installment on December 31, 2019 and will bear interest at a rate of 13/16% per annum over the six-r-nth LIBOR rate for the currerncy in which the bonds are issued. (Bonds will be issued in: Canadian and U.S. Dollars; Belgian, French and Swiss Francs; Deutsche Marks; Dutch Guilders; Italian Lire; Japanese Yen; and Pounds Sterling). Payment of the full principal amount of the Discount Bonds on December 31, 2019 will be secured by a pledge by Mexico of zero-coupon U.S. Treasury obligations (or other comparable collateral for other currencies). Payment of interest will be secured by a pledge by Mexico of cash or permitted investments in the currency of the bonds in an amount equal to  14 eighteen months' interest (calculated at a constant interest rate of 10% per annum in the case of discount bonds issued in US dollars). Option B: Collateralized Fixed Rate Par Bond Exchange. Creditors may exchange eligible debt for Collateralized Fixed Rate Par Bonds issued by the United Mexican States in a principal amount equal to 100% of the principal amount of eligible debt offered for exchange. The Fixed Rate Par Bonds will also be in registered form; will be issued in the same ten currencies as under Option A above; and will mature in one maturity on the same day as the Floating Rate Discount Bonds. The interest rate payable on the Fixed Rate Par Bonds will be 6.25% per annum for those issued in U.S. dollars and corresponding rates for those issued in other currencies. Principal and interest payments on the Fized Rate Par Bonds will be secured in the same fashion as for the Floating Rate Discount Bonds, except that instead of using the assumed constant interest rate concept, the interest payments on the Fixed Rate Par Bonds will be secured to their full contractual levels. B New Money Options Option C: 1989-92 New Money Credit Agreement. Lenders may elect to commit to lend up to 100% of their New Money Commitment (defined as 12.5% of Facilities 2 and 3 advances under the 1987 Multi-Facility Agreement and 25% of all other eligible debt) in the New Money Credit Agreement which will provide the United Mexican States (with an undertaking by Banco de Mexico to provide foreign exchange) with a 15 year (7 years grace) loan at an interest rate of (a) 13/16% over LIBOR, or (b) 13/16% over the three months Certificate of Deposit rate or (c) a fixed rate calculated to provide a comparable yield to maturity as the floating rate options. The loans will be made in the same currencies as the Debt and Debt Service Reduction Bonds, except that European Currency Units can also be lent under the New Money Credit Agreement. Amounts under this Agreer nt will be available for disbursement in six semi-annual tranches commencing on December 1, 1989 and concluding in July 1992. The first tranche will permit the disbursement of 40% of the loans and each subsequent tranche will permit the withdrawal of 12%. Option D: New Money Bonds. Each creditor may elect to purchase New Money bonds in an amount up to 50% of its New Money Commitment, although not more than $500 million of New Money bonds will be issued in total. New Money Bonds will be issued by the United Mexican States; they will be in registered form, issued in U.S. dollars; and will bear interest at the rate of 13/16% over LIBOR. They will be issued on the date of the borrowing of the first tranche under the New Mcney Credit Agreement, and will be repayable in equal semi-annual installments beginning in 1997 and ending in 2004 (15 year maturity, 7 year grace).  15 Option E: Onlending Facility. Up to a limit of 20% of its New Money Commitment, each creditor may elect to make advances to a trust established by Mexico (with Banco de Mexico as trustee) for the purpose of onlending funds to Mexican public sector borrowers with the guarantee of the United Mexican States. These advances will have the same repayment schedule as the loans made under the New Money Credit option (15 years maturity, 7 years grace), at an Interest rate of (a) 13/16% over LIBOR, or (b) 13/16% over the three months Certificate of Deposit rate. Advances made under the Onlending Facility may be in any of the currencies permitted under the New Money Credit Agreement; and the same restriction on availability applies as the one on loans under the New Money Credit Agreement. Option F: Medium-Term Trade Credit Facility. Up to a limit of 20% of its New Money Commitment, each creditor may elect to make advances to a trust established by Mexico (with Banco de Mexico as trustee) for the purpose of financing certain eligible trade credits (e.g., unguaranteed portions of bilateral trade credits to Mexican public sector borrowers, or trade credits to Mexican private sector borrowers for transactions approved by Mexico). The Medium-Term Trade Credit Facility will have the same primary terms and conditions as the Onlending Facility. Creditors holding claims in their home currency can, if that home currency is not the US dollar, choose whether to maintain the original currency denomination or switch into US dollars. If they choose to remain in their non-dollar home currency, the total funds devoted to enhancement will not exceed what would have to be provided for an equivalent dollar claim. l Banks holding Mexican obligations contracted in the 1983-88 period will reschedule them to 7 years grace with 15 years maturity to the extent they are not swapped for par or discount bonds. Mexico's external creditors would provide all the necessary w.ivers to make feasible the issue of new debt and debt service reduction instruments with credit enhancement. The Government would be entitled to buy back any of the newly issued discount or par bonds if (a) it is current on interest payments, and (b) the collateral account for interest support is either not drawn upon or replenished. This latter restriction lapses after end-1994. Mexico would continue to service the incerest on its existing loans on their contractual terms until the exchange takes place. However, the terms of the agreement would, upon signing, be implemented with retroactive effect from July 1, 1989. For the new money commitments, this implies that at the time of the signing, participating banks would disburse immediately all the installments due until and at that time, subject to the satisfaction of certain conditions precedent (which include the issuance of the discount and par bonds). Similarly, once the discounted and par bonds are issued, Mexico i/ There is one exception to this rule. Up to 5% of the Yen-denominated debt held by Japanese creditors is eligible for full collateralization of principal through zero coupon bonds and 18 months of interest coverage.  16 would deduct from the initial interest payments the amounts of interest paid on the exchanged loans in excess of the interest due on the new bonds, after July 1989. This clause was introduced to eliminate any possible perverse incentive on the part of the banks to delay the signing of the agreement. C Debt-Equity Conversion Banks participating in the 1989-92 financing package will have access to a debt/equity program which would be authorized up to $1 billion per year. This program would be limited to public sector companies that are being privatized and to qualified infrastructure projects. The lower limit of discount would be 35% on par bonds, new money and eligible old debt, and the conversion of discount bonds would not be higher than the face value. D Recapture Clause Banks that have chosen discount or par bonds are eligible to recover some of the money given up through a "recapture clause". Under this clause, beginning July 1996, 30% of the additional oil revenues Mexico gets if the price of oil rises above $14 per barrel (to be adjusted for US inflation), will accrue to the banks that have granted debt and debt service relief. The total amount to be recaptured, however, will not exceed in any year 3% of the nominal value of the debt exchanged for debt reduction instruments at the time of the exchange (i.e. there is no indexation of this cap) Furthermore, the amount available under this clause will be scaled back by the percentage of the total debt brought under the two debt reduction options. These recapture clauses, once attached to new instruments, can survive early redemption of such instruments by at most five years. E Credit Enhancement All discount and par bonds will be repaid in a single installment on December 31, 2019. The principal would be secured by the pledge of zero coupon US Treasury obligations (or other comparable securities for bonds in other currencies) with a maturity date matching that of the Mexican bonds. In addition, interest payments would be partly secured by a pledge of cash or permitted investmenits in the relevant currencies for an amount equal to 18 months of interest payments due. 6/ The securities and cash pledged as collateral will be held in special collateral accounts, to be managed by the Federal Reserve Bank of New York, as collateral agent.Z/ Creditors' debt service would be paid out of these collateral accounts in case the Government failed to make interest payments for longer than 30 days, for as long as there are funds in the accounts. To enable establishment of the special collateral accounts, waivers of the negative pledge restrictions are necessary and have been received from Mexico's commercial bank creditors. j/ That is, covering three semi-annual interest payments. 7/ More than one account may be needed to secure interest payments denominated in different currencies.  17 The bondholders will appoint the Federal Reserve Bank of New York as collateral agent to hold the collateral for discount and par bonds for the benefit of the bondholders in the various currencies in which the debt exchange instruments are subscribed. The collateral agent, whose appointment would be set out in collateral pledge agreement with the Government, will open the collateral accounts and deposit into those accounts the cash and securities available for interest support. Interest earned on the funds held in the collaterai accounts will be released to the Government. The balance in the collateral accounts, once the bonds for which interest support was provided have matured, will be returned to the Government. To implement Mexico's credit enhancement scheme for the discount and par bonds, it is necessary for the Government to obtain limited waivers of the restrictions against giving security on other external debt -- the negative pledge restrictions -- contained in agreements that Mexico has entered into with the World Bank, IDB and other external creditors including the commercial banks. As the Morgan bonds were secured and had no negative pledge restriction, those bond holders did not have to be consulted. Table 3 ENHANCEMENT FUNDS REQUIRED (US$ billions) T T Discount Par Total Bond Bond Principal collateralizaton: 1.18 2.22 3.40 Interest Coverage 1.82 2.11 3.96 Total : 3.00 4.36 7.36