SUNS4514 Thursday 23 September 1999

Finance: Small countries pose big challenges

ashington, Sep 22 (IPS/Abid Aslam) -- World finance ministers gather here next week for talks on changing the 'architecture' of the global economy that could be eclipsed by a very small country - Ecuador.

President Jamil Mahuad last month deferred key interest payments and announced he would seek to restructure the foreign debt - half of it in 'Brady bonds', long considered sacrosanct by governments and markets alike.

That decision has put the Andean nation of 12 million people at the centre of a fight between public and private creditors over how they should respond when a country is embroiled in crisis. The outcome will have far-reaching consequences for the 'architecture' debate, aimed at improving the steadiness of private capital flows - and the 'real economy' of factories, farms, and homes increasingly at their mercy.

"The 27th or 28th of September, when the annual IMF (International Monetary Fund) meetings start, the government will announce its strategy to restructure its Brady bonds," says Central Bank President Pablo Better. Bondholders will be given a "menu" of restructuring options from which to choose, Finance Minister Alfredo Arizaga adds.

If Ecuador doesn't reach an accord or make the interest payment by month's end, it will become the first country in formal default. In turn, that could trigger another unprecedented default - on a $500 million Eurobond.

Brady bonds, created in 1989, are named after Nicholas Brady, the US Treasury Secretary under George Bush. They consist of old commercial bank debt already written down by international banks. After reducing the nominal value, Third World debtor countries secured the remaining debt with 'collateral' in the form of US
Treasury bonds, which they deposited in a special account at the New York Federal Reserve Bank.

The arrangement had been touted as the solution to the 1980s debt crisis, allowing debtors to re-enter foreign capital markets and enabling creditors to salvage - rather than write off - their loans.

In Ecuador's case, foreign banks agreed to knock down the value of their claims by about 40% - and in so doing won 'collateralised' guarantees that their principal would be repaid, with some interest.

The IMF has publicly supported Ecuador's efforts to restructure its $13 billion in public foreign debt, including the Brady bonds, though heat from private financiers has forced IMF now to take a more disinterested stance.

Official creditors have been stung by criticism that they are bailing out private lenders with public money - thereby encouraging risky lending while dumping the cost of their 'rescues' on borrowing countries' taxpayers.

That is why the IMF and 'Paris Club' of bilateral lenders also have insisted that Pakistan, Romania and Ukraine give equal treatment to their private and official debts and not use international loans to pay off private creditors - the norm until now.

The precedent-setting cases involve minuscule economies but private financiers are upset. They face losses on claims they've already discounted and they fear that other troubled economies will follow suit.

As one observer puts it: "Turkeys, after all, do not vote for Christmas."

Ecuador's annual economic output - roughly $15 billion - is less than what the United States produces in a day. Its public foreign debt also is relatively small - $13 billion, compared with more than $70 billion for Brazil.

Nevertheless, a default by Ecuador would undermine Western investors' confidence in a developing-country bond market valued at more than $300 billion, financial analysts warn.
"Why cripple emerging markets over such penny-ante stuff?" says William Cline, deputy managing director of the Institute of International Finance (IIF), the lobby group of 300-plus banks and investment houses. The IIF objects to officials' suggestions that bond contracts include "collective action" clauses, which would place blanket requirements on private holders of sovereign debt.

Without such mechanisms, restructuring Brady bonds is a more complicated process than negotiations with commercial banks in the late 1980s. That is because the bonds are held by hundreds of private investors - including junk bond traders - and the majority must approve any proposed rescheduling.

According to the IIF such conditions would disrupt the market and force some countries to pay bigger returns in order to secure investment in their bonds, the IIF argues.

Some bankers, however, disagree.

Members of the French Banking Association say they are ready to accept changes that would boost the role of private investors in resolving countries' troubled debts. In their view, the important thing is that all bond contracts - not just those of emerging economies - include the new clauses. Indeed, the French bankers say in a statement, the process could begin with bonds issued by wealthy countries.

Brady bonds account for six billion dollars of Ecuador's public debt - or about half of a foreign debt burden that exceeds 90% of gross domestic product (GDP).

Servicing that debt will consume about 42% of this year's national budget - at a time when Ecuador is facing its worst economic crisis in 50 years and the economy is expected to shrink seven percent in 1999.

Brady interest payments this year will cost the country some $279 million.

Starting in 2000, principal repayments will be added, raising servicing costs to $289 million- then to $326 million in 2001 and $721 million in 2002, according to official figures.

Ecuador has no choice other than to restructure its Brady debt, officials and analysts say.

'Bradies' have never been renegotiated because they are not meant to be, market analysts say. If a country were to default, bondholders could approach the Federal Reserve and demand the bonds within 30 days.
Even if they don't do that, they could sue Ecuador, dragging the government into protracted court proceedings.

Clouding the outlook, talks with the IMF over an 18-month stand- by loan have dragged on for eight months. Agreement would unlock $400 million in IMF financing and one billion dollars from the World Bank and Inter-American Development Bank.

An IMF deal has been agreed in principle, says a senior official here, but it hinges on the government's ability to overcome three obstacles: overcome popular opposition and close its budget deficit by raising taxes; cut off politically-influential domestic financiers from further bail-outs of their troubled banks; reach a "friendly solution, and fast" with foreign creditors who - at least for now - appear extremely belligerent.