Debt to Equity Swaps
There is too much financial leverage in the world. Governments all over the world owe a massive debt to private creditors. This is not the first time that this situation is occurring. The case was exactly the same in Latin American countries in the early 90s. Nations which had been prudently paying their debt had suddenly started defaulting on their loans. It was during this period of crisis that debt to equity swaps in sovereign debt became a norm. The same situation is arising once again and it is likely that these swaps might once again make a comeback. In this article, we will have a closer look at how these swaps work and what their pros and cons are.
How Debt To Equity Swaps Work?
In simple terms, a debt to equity swap is simply a method of extinguishing debt. Normally countries and companies have to pay out cash to extinguish their debt. However, if the borrower and lender both agree then the payment of cash is no longer necessary. Something equivalent the value of cash can also be paid instead of cash. In case of debt to equity swaps, loans are extinguished in favor of equity. In these transactions, the lender usually receives less than the face value of the debt but more than the depreciated market value. Hence, both parties are better off. The creditor takes a smaller haircut and faces the possibility of future growth. On the other hand, the debtor no longer faces default and the ill repute that it brings along.
There are many investment firms which specialize in debt to equity swaps. They purchase the debt from the bond market at slightly higher prices. Then they use the debt as payment for purchasing public assets. This debt can also be exchanged for equity stakes in government-owned enterprises such as banks, oil refining companies and so on.
Benefits of Debt to Equity Swaps
The most common of debt to equity swaps are as follows
- Prevents Default: Defaulting on international debt creates a host of problems for the borrower nation. The interest rates spike as the bond values fall. This makes it difficult for even the private sector to obtain credit on favorable terms. As a result, the entire economy goes into a tailspin. Debtor nations do not want this situation to arise. Hence, they are sometimes willing to privatize some of their assets if this can prevent default and leave the local economy unharmed.
- Increases Investments: it is important to note that debt to equity swaps retain the investments within the nation. This is opposed to what would happen in s default scenario. As soon as the news of default reaches the market, a large scale exodus begins. No matter how favorable the foreign investment policy is, investors will make a beeline to exit an unstable country. Governments can prevent this by using swaps. Also, many governments only enter into swaps if investors are willing to invest even more capital into the private sector. In this case, the swap is a good way to mitigate what would have been an economic disaster.
- Cheaper Alternative: If the bond market knows that a nation does not have its finances in order, the yields on their bonds tend to increase. Hence, the cost of rolling over debt i.e. replacing old debt with new one increases substantially. In this case, it makes more economic sense for the country to enter into debt to equity swap. The internal rate of return on the debt to equity swap is less than the asking interest rate of the bond market. This is the reason why many Latin American countries willingly entered into debt swap agreements during the 90s.
The debt to equity swap method also has several disadvantages. Some of them have been listed below:
- Distressed Sale: When countries are trying to swap their debt for equity, often they are not in a commanding position. This means that the private sector tends to take advantage of the situation. In many swaps, it has been noticed that the assets that were given over far exceeded in value what was owed to the lenders. This is often made possible when the book value of the assets is much less than their market value. Private investors resort to corruption and bribery to get control of these assets. Also, many times private investors get hold of strategic assets such as water or cooking gas and then start charging exorbitant amounts. Debt to equity swaps have become a way for corrupt politicians to hand over national wealth and natural resources to foreigners.
- Hyperinflation: When debt to equity swaps are made for debt denominated in foreign currency, it first needs to be transferred to local currency. As a result, a lot of local currency is printed and injected into the economy. If this continues for a longer period, then the additional currency tends to produce rapid inflation which can then turn into hyperinflation and wreck the entire economy.
Hence, debt to equity swaps is a good method for extinguishing unpayable debt. However, it needs to be ensured that the population of the debtor nation is not exploited in the process. However, it is difficult to ensure this since the media, and the general population does not have any information about these deals until it is too late.
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