PERSONAL & CONFIDENTIAL
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normally. But since 1987 the banks, led by Citibank, have generally established reserves or provisions typically worth 30-35% of the debt outstanding to bad debtors set aside from their profits to cushion them in the event of default. Provisioning lessens the need for the banks to lend further to protect their existing exposure, and adds the further disincentive that any new lending to bad debtors increases the amount they must deduct from their profits in provisions.
4. Against this background of a huge debt overhang and the banks' growing reluctance to engage in new lending, it is natural that attention should switch to schemes for debt reduction. There are already a number of voluntary debt reduction options in the so-called menu that governments and the Fund have commended to banks and debtors alike. The most significant so far is the debt-equity swap, whereby banks (or investors who buy from the banks) redeem the debt in local currency at a discount (but still substantially above the debt's secondary market price) and invest the proceeds in the debtor country. The latter benefits from the redemption discount; the investor from the premium above the secondary market price. The local regulations governing investment and the repatriation of profits determine the attraction of this option to the investor. Chile's relatively liberal incentives and hitherto stable regime make it attractive to foreign investors. Progress elsewhere has been patchier.
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5. Enthusiasts for debt-equity swaps argue that they replace a fixed repayment obligation with one dependent on the success of the enterprise; and that they help to attract new direct investments and technology transfer. Sceptics argue that little of the investment is additional: the swaps simply allow multinationals to invest on the cheap. They also argue that unless the Government can swap State enterprises for the debt as part of a privatisation programme (much of Chile's debt reduction was achieved in this way) the Government has to find large additional sums of local currency to swap for the debt. There are ways of sterilising this effect - for example by issuing bonds but the risk of inflation remains.
6. Like the debt-equity swap, but on a smaller scale, is the debt-charity swap. A charity buys or is given debt and swaps it for local currency to be used in conservation or development projects. A recent example is Midland trasferring its small Sudanese debt to UNICEF. Brazil has even arranged a debt-for-footballer swap. These schemes attract interest quite out of proportion to their importance for the debt strategy, as our mailbags show.
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Far more important are schemes where debtors issue bonds in exchange for debt. The banks need an incentive to swap their debt for bonds with a lower face value or lower interest payments. This can be done by providing some sort of collateral to guarantee repayment of this securitised debt. As you know,
SSLAKR
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