THE TROUBLE WITH SWAPS

THERE IS A LOT OF EXCITEMENT in the international financial community these days about using debt/equity swaps as a means of reducing the debt burden of developing countries.

With more and more bankers coming to the realization that new money - and thus expanded debt - is not the answer to the debt crisis, these swaps are viewed as an attractive way to 1) reduce the LDC debt and 2) insure that creditors get something back from their poorly performing loans.Yet Latin American leaders, and at least one renowned economist have their doubts about the merits of these swaps. Their concerns are justified.

This is roughly how debt/equity swaps work. Bank A seeks to sell off its loan at a discount to Manufacturer B. The size of the discount on the loan in the secondary market varies from country to country. Mexican debt in the secondary market sells for 60 cents on the dollar, Argentine debt for 63 cents, Venezuelan for 77 cents, Bolivian debt for 7 cents and so forth.

Manufacturer B transfers this debt to its subsidiary in Country C where the central bank converts the currency at about par. That money is then used to beef up the operations of the subsidiary in Country C and stimulate the local economy. Theoretically, that is how the plan works. Banks take a loss, but at least they get something back from their loan. The manufacturer gets cheap capital to invest. And the central bank has an international loan taken off its books.

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A NUMBER OF ECONOMISTS are enthusiastic about the idea. James Robinson, chairman and chief executive officer of American Express Co., says debt/equity swaps could result in a 25 percent to 30 percent reduction in the $70 billion outstanding debt owed to U.S. banks by Latin American nations. Lawrence Kudlow, chief economist for Bear Stearns and Co., says the swaps stimulate local economies and aid the repatriation of flight capital. Rimmer De Vries, senior vice president at Morgan Guaranty Trust, says the swaps are "not a solution to the debt problem" but may whittle away up to $5 billion a year

from the debt burden in some countries.

To date, Brazil has approved roughly $1 billion in debt-to-equity conversions. Chile has approved $1.5 billion or about 8 percent of its $20 billion debt. Mexico is converting debt to equity at the rate of $100 million a month, and by year's end it will have concluded about $750 million in swaps.

From all the commotion, it would appear that these new instruments are the answer for all that ails the developing countries. But clearly this is not the case. Debt/equity swaps are, at best, only part of any overall solution to debt reduction. There is even some evidence to suggest that the conversions might be a deterrent to direct investment in debtor countries.

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RUDIGER DORNBUSCH, professor of economics at the Massachusetts Institute of Technology, calls the swaps a form of "glorified foreclosure." He believes they could result in an increased debt burden for the Latin American governments. Rather than borrowing from foreign banks at 8 percent to 9 percent interest, he says, debt/equity swaps force Latin central banks to borrow domestically at much higher rates of interest, on the order of 30 percent.

Likewise, he says, swaps represent a government subsidy for foreign investors, since many of them would have invested in these countries anyway. In Mexico, he says, the increase in debt/equity swaps is matched by an equal decline in direct investment.

Some financiers dismiss Mr. Dornbusch's arguments since he is an academic rather than a banker. But it is precisely because he is not a banker that Mr. Dornbusch's arguments deserve careful consideration. As an academic, he is a disinterested party in such transactions.

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LEADERS IN DEVELOPING COUNTRIES share Mr. Dornbusch's concern. Brazilian Finance Minister Dilson Funaro, says swaps bring "a high cost" to debtor governments. Sonita Monsod, director general of the National Economic and Development Authority of the Philippines, is worried that debt/equity swaps may result in "round-tripping," a practice by which the foreign investor makes a tidy profit on the currency conversion and then pulls his money out of the country - leaving the central bank with a loss and the debtor country without the foreign investment it so badly needs.

Debt/equity swaps have a role in debt reduction. They may well act as an anchor to stem the flow of flight capital. They may also stimulate domestic economies. But the potential for exploitation - by foreign multinationals or by banks creating a market for swaps - is real indeed.

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