Western capital's role in privatizing post-communist economies: The issue of debt for equity swaps in Eastern Europe

Abstract

The international debt crisis which erupted at the beginning of the 1980s has called for unconventional, radical and imaginative solutions to the problem of Third World indebtedness. By the end of 1990, five such solutions had been developed in some detail [Dooley M.P. et al., 1990; Twentieth Century Fund, 1989]. One of them, called debt for equity swaps (DES), was devised in the late 1980s. It is therefore a relatively new phenomenon. At the most fundamental level, the DES technique consists of two steps: the substitution of internal for external debt (external debt buy back); the retirement of internal debt by way of converting it into equity in the existing or newly created domestic companies (foreign investment). The idea of DES has sprung from the secondary market for developing country debt. Such a market grew spontaneously by way of securitization of debt or unloading individual bank loans onto a broader spectrum of economic agents which then became players in the market. In cases where the market valuation of debt differs substantially from its nominal value (that is, substantial discounts are offered), there is an opportunity for the creditor to acquire debtor country assets through investment at an exchange rate which is more favourable than the official or prevailing one, provided the debtor country has such a programme. Besides the obvious "weeding out" of the illiquid portion of the portfolio without depressing the secondary market, this selective devaluation of the debtor country currency lies at the heart of its attractiveness to creditors. Actually, it represents an implicit subsidy given by the debtor country to the creditor and/or its partners willing to invest in that country. The inner workings of the phenomenon are as follows. The party interested in making an investment in the debtor country acquires a foreign debt obligation of that country in the secondary market. The purchase is usually made at a discount over the face value of the obligation because creditors are willing to take a loss rather than risk maintaining the asset in their portfolio. The obligation can then be converted to a local asset in the debtor country such as local currency, a locally denominated debt obligation, or equity in the entity owing the debt. By exchanging the foreign debt obligation acquired at a discount, the purchaser of the debt can obtain local assets at an attractive ex-