Voluntary Debt Reprofiling: The Case of Uruguay
Carlos Steneri Ministry of Finance-Central Bank of Uruguay Prepared for the Four UNCTAD Conference on Debt Management, Geneve, 11-14 November 2003
Voluntary Debt Reprofiling: The Case of Uruguay
1. Introduction During the nineties Uruguay was one of the most successful stories as an issuer of debt in international capital markets. Clean credentials stemming from its longtime performance as a reliable debtor together with the implementation of sound macroeconomic policies paved the way to tap markets paying low yields and getting long maturities during the nineties. In 1997, Uruguay sovereign debt was rated Investment Grade by Standard & Poor's and Moody's and Ficht. In the same year was able to issue a 30 year bond maturity, in dollars, with a spread over U.S. Treasuries of 136 basic points. This fact together with other further issuances in
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local moneys (ej. Chilean peso), in the Eurobond and Japanese capital markets meant that the country had reached the zenith as an issuer of foreign debt. In fact, the country had joined the exclusive club of emerging economies which issued investment grade debt. In Latin America, only Chile and much later El Salvador and Mexico pertained to that exclusive category. A sudden reversal in the capital markets mood put in motion a chain of regional events which triggered in Uruguay the deepest financial crisis in recent history. As a consequence , the capability to service the debt was severely imperiled, obliging to find a solution to that unexpected problem.
1. The road to the debt crisis. The Russian debt default in 1998 promoted the reversal of the financial flows directed to the emerging economies. This fact had important consequences, in particular on Uruguay’s surrounding big regional economic partners. Brazil was obliged to float its currency in January 1999, given place to a sharp contraction in its domestic absorption. As a result, its demand for regional exports plunged, irradiating deflationary pressures over Uruguay and Argentina, which at the end will have strong adverse consequences on both countries. At that time, Uruguay's policy makers perceived that that negative external shock stemming from Brazil was temporary. That line of thinking was a consequence from the lack of historical antecedents indicating that a "real" sharp devaluation of the Brazilian currency could last for long. Regional economic history taught that sharp exchange rate
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nominal devaluation were followed by an equivalent increase in domestic inflation. Therefore, the real exchange rate after a short period, stay unmodified at the same predevaluation level. But this was not the case. The expected surge in inflation did not take place and a substantial real exchange rate devaluation continued. But that piece of information was nor available ex ante and Uruguayan authorities decided to apply short term countervailing policies. This was translated to the implementation of countercyclical actions to compensate, what was believed to be a short run phenomena .In consequence, Uruguay put in place during 1999-2000 policies financed mostly with external debt. This fact began to deteriorate the strength of the country external accounts. However, given the assumption of the short term nature of the deflationary forces, the administration believed that the situation could be managed through a gradual process of reducing domestic absorption, the relatively comfort of a high cushion of foreign reserves and the implicit postulate that the country would be able to roll over the debt maturities through continuous access to capital markets. The collapse of the Argentinean economy was the trigger for a sequence of unexpected shocks. The inflexibility of its relative prices- stemming from the Convertibility law and wage rigidities- together with endemic fiscal imbalances were the original causes that impeded an orderly but necessary adjustment in that country to mitigate the negative external shock. The final outcome was a ladder of desperate economic policy changes that added more noise than solutions to an unstable situation. Central to this economic policy misconceptions were the partial modifications of the exchange rate regime and the implementation of a domestic debt exchange which did not give major benefits in terms of cash flows alleviation. These actions were taken without solving two basic problems
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that lead to the critical situation: the endemic fiscal imbalances, and the unsustainable exchange rate appreciation promoted by the rigidities of the macroeconomic environment. These inflexibilities lead to a sharp increase in unemployment, a substantial GDP contraction and a further deterioration on the fiscal accounts within the context of a sudden stop in the availability of external financing. The financial sector was next in the line to suffer the consequences. Its implosion was the beginning of the end.. The Convertibility Law was abandoned in 2001, Argentina's GDP growth collapsed (more than 12 per cent during 2000-2), and the currency depreciated in real terms more than 150 per cent. The financial sector suffered a series of mistaken policies first the asymmetric “pesification” of bank balance-sheets, and then with the frozen on bank deposits. All these lead to a credit crunch which put further pressure down on economic activity. As a result, conditions for regional contagious were set, being Uruguay its first casualty Facing these facts, Uruguay tried to weather the storm through the acceleration of the crawl of the devaluation path (early 2001) together with a drastic reduction of public expenditures in real terms. These measures were not enough to neutralize the negative impact stemming from Argentina being the result an erosion on economic activity. A series of banking malpractices discovered in Uruguay (1Q 2002 ) ignited the strongest financial crisis on the country recent history. An unstoppable run on bank deposits began, (May 2001) depleting during a short period of time the Central Bank reserves and leading to the need to float the currency to protect the scarce reserves remaining. To face the banking crisis, the international community through the IMF, put in place a special aid
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financial package (1.8 billions dollars). As a result, the government decided to reprogram public bank deposits and liquidate four insolvent private banks. The rapid deterioration of the financial system had a severe impact on credit lending, resulting in a vicious cycle of less credit and then further additional economic contraction. The depreciation of the currency reduced nominal GDP in dollars by more than 50% (US$ 23b in 1998 to US$11b in 2003).
Finally, the proud creditor went to ashes unexpectedly. The country capabilities to honor its debt obligations were dramatically imperiled, when year 2003 already presented a challenging calendar of debt maturities. The prolonged reversal in financial flows to the
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emerging economies (sudden stop) and, the deterioration of Uruguay's terms of trade, posed an additional constraint to solve the problem through conventional means.
2. Searching for the way out
Uruguayan authorities faced a twofold challenge: to preserve its status as a trusted creditor and obtain simultaneously debt alleviation. The only feasible way to achieve those two apparently antagonic objectives was through the implementation of a voluntary debt exchange, which assured creditors' rights and provided a feasible external payments calendar given the country ‘s economic conditions. In this matter, no international experience was available. Most recent debt exchanges (Ukraine, Pakistan, Ecuador) in one sense or in another were not voluntary and emasculated the respective creditors' rights. To the eyes of Uruguay's authorities, any of them were not a suitable strategy to follow. Moreover, the international financial community looked like not to be well prepared to offer a suitable alternative to solve the problem. The IMF, directly engaged in these previous recent debt exchanges, agreed on mechanisms not suitable to Uruguay's needs. Besides, IMF new thinking about how to solve this type of crisis was connected with the Sovereign Debt Restructuring Mechanism (SDRM). This approach pursued the implementation of an “statutory “ framework containing general and universal rules and new institutional frameworks to address debt problems. The SDRM basic building blocks are the following .First, an agreement between debtors and a special creditors'
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majority has to be in place Second, during debt negotiations legal protection to debtors has to be provided. Third, the uniformization of negotiations criteria through the creation of an independent forum. Finally, the IMF chart have to be modified to allow its participation in this kind of procedures.. In consequence, from Uruguay's view point, these strategy was divorced with the principles applied in a voluntary debt exchange strategy. The polar alternative to that approach is the utilization of Collective Action Clauses (CAC), which could be defined as a “ contractual approach” achieving the goals through the universal application of this type of clauses already included in a wide spectrum of financial instruments, mostly in the private sector. The basic idea behind this approach is to regulate the manner trough which debtors and creditors voluntarily could modify bond terms using special vote majorities Other market friendly alternatives were flying around, but at that stage they were quite primitive and incomplete. Therefore, given the state of the art to induce an exchange suitable to Uruguay objectives, the most suitable road was to combine Collective Action Clauses to be included in the new exchange bonds, with the utilization of Exit Consent. Its objective is to stimulate bondholders participation penalizing potential hold outs. In financial terms the exchange has to create value , but preferably only to participants, discriminating against free riding strategies. The challenge was then the designing of a course of action in which both creditors and debtors will be better off playing a sort of game applying cooperative strategies. In short, the goal was to implement a voluntary exchange through which the creditors accepted to
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provide with some sort of debt alleviation and the country generating value to participants through policies directed to strength its economic growth and in consequence invigorating its debt service capabilities. If the game was not played in a cooperative way, the country would be forced by the circumstances to default the debt and all parties involved will suffer additional losses. A crude example is the following. At the time of the prexchange Uruguay debt quotation was around 50c -the typical level for distressed bonds. If the game (exchange) was played cooperatively, a substantial upside in price quotations was expected (40-50%). To the contrary, if the country defaulted its debt, its quotation would plunge to levels close to 15-20c. The potential losses of the bad outcome behaved as a deterrent to behave as a maverick bondholder. But in any case, these facts did not fully diluted the temptation to hold out during the process, and being benefited for free riding the deal. In fact, the collapse of the deal was an event with non-zero probability.
3. The design of the overall strategy
The strategy to design a voluntary debt exchange minimizing the temptation to free ride relied on some basic building blocks. The first one, and starting point, was to approach markets with the purpose to convey them that a liquidity but not a solvency problem arise, due to the extreme adverse regional conditions. Also that the country is willing, as in the past, to fully honor its debt obligations, fact disrupted by extraordinary events which required extraordinary actions in consultation with creditors.. .
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In medical terms, the idea to convey to bondholders was that cost of default prevention (debt alleviation) was cheaper than an aggressive cure (unilateral default). This approach showed that Uruguay aimed at to continue servicing the debt setting aside the option of any unilateral disruption in the flow of debt payments. Central to the approach was to show that ”willingness to pay” was ever an essential attitude of the country. The challenge then was to present adequate arguments that make credible that kind of behavior. In practical terms the exchange had to provide breathing room as a way to wait for the improvement of external conditions and to regain economic growth, both preconditions to dissipate the liquidity problem in place. Therefore, a message to convey was the need to reduce external payments during certain period. In other words, the draft proposal envisaged some ideas about some sort of bond maturities extension , but not any mention to any explicit cut in nominal bond values. The strategy ‘s likelihood was helped by the fact that most of Uruguay’s debt was contracted paying low fixed coupons short term maturities were not substantial. Both characteristics are quite exotic for emerging economies and showed the good debt management in course. Therefore, substantial debt alleviation could be achieved only through ”extension bond maturities”. Also during the talks with market players, the announcement since the beginning of the equal treatment of domestic bondholders vis a vis foreign creditors was crucial to assure that each creditor category would be asked for the same doses of sacrifice to help to achieve the outcome. In the same vein, the financial exchange structure had to be time equivalent all along the curve . Therefore, by definition the Net Present Value reduction
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of the exchange was equivalent along the entire yield curve (swap equivalence). In other words, all bonds -independently of their maturity- should face the same "sacrifice". (haircut). The inclusion of the polemic issue of Exit Consent was presented as a way to protect participants from potential free riding rather than a tool to force the exchange. Finally, the approach likelihood was facilitated by the relatively scarce dispersion of creditors (most of them international), and the low exposition of the domestic banking system to Uruguay's debt. This fact assured that the financial sector already weakened by the crisis will not suffer additional damage through the exchange.
4. Some notes on the consultative process
The consultative process was a prior action to the final design of the debt exchange strategy. Its purpose was to convey information to all market players (including multilateral institutions) to promote the conditions needed to articulate a cooperative game among all parties involved. Uruguay authorities believed that the challenge ahead was to induce a cooperative behavior between the debtor and their creditors, in a game where some sort of a "prisoner dilemma" was in place. Using one of the known feasible outcomes of this traditional game theory example, a way to induce a cooperative behavior was to provide information to the "prisoner A" (creditor) of what attitude the country (prisoner B) will take if the other side accepted to play the game under certain circumstances. Given the traditional result if prisoner A
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cooperates ( participates in the exchange and gets new bonds) and prisoner B has the same cooperative attitude (pays the new bonds but put some uncertainty –exit consents on payments of hold outs) both parties will be better off . The non cooperative solution (no participation-default) at the end will be more expensive for both parties. These are in a nutshell the forces that drove the exchange. The trick was how to unleash them. In fact, the debtor had more information about the likelihood of the different alternatives (i.e. future economic policy, treatment of free riders, NPV equivalence along the curve, and equal treatment between domestic and international creditors and even the likelihood of default). Therefore, a necessary condition to force cooperative strategies was to share information and to get the feedback from creditors on different issues to be included in the final proposal. During that process launched informally in the second half of March 11, 2007, the market players showed a mature and deep knowledge of the forces that drove Uruguay to the difficult situation, the risks involved, and the potential benefits if the exchange was successful. From the beginning, they understood that a cooperative strategy had a high up-side in bond market quotations. Conversely, a failure could mean additional losses, plunging bond prices to default levels (15-20 c). The main message received as a condition to participate in the exchange was their preference for a straightforward maturity Extension Alternative rather than to accept principal or coupon reductions.
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Second, they showed concern about the potential liquidity of the new instruments. The answer was the acceptance to provide a benchmark bond alternative. Thirdly, intercreditor equality treatment was raised several times (local versus international, short versus long maturities). In consequence, the preservation of the relative terms structure along of the curve through comparable Net Present Value impact on all bonds was a determinant on the final design of the proposal. Finally, Collective Action Clauses (CAC) was accepted without resistance, in spite of the fact of the inclusion of "aggregation", through which a super majority could modify each bond (i.e. maturity, money, coupon) if a minimum vote is reached in that class. In fact, the "aggregation" provision gives some sort of insurance covering the risk of any potential future distressful event, though the action of a super majority vote which tries to synchronize actions, benefits and penalties among bondholders who are trying to solve the problem. In conclusion, the consultative process confirmed most of the initial assumptions that laid ground for the building of the exchange proposal
The inclusion of CAC and Exit Consent
The exchange proposal included state of the art legal tools. From the start it is important to highlight that the legal components played a crucial role in the goals achievements. This type of exchanges is a mix of financial engineering coupled wit sophisticated legal provisions surrounded by an exercise on persuasion about the feasibility of the actions proposed, all of that is directed towards market players.
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Previous exchanges (Pakistan, Ukraine, and Ecuador) were not voluntary in one sense or in the other. As was already said, Uruguay authorities faced the challenge to set conditions through which all parties involved pursued a cooperative strategy during the exchange process CAC inclusion assured that a cooperative game could be played in the future, if needed, without major disruptions either through a global exchange or in a bond by bond basis. This assured to promptly wipe out potential risks of insolvency when a liquidity problem arises due to the fact of the impaired payments flows. According to our view, CAC inclusion is crucial to assure voluntary creditors participation if problems arise. It is a close substitute to provisions applied to private debt in distress (Chapter 11), in order to find a less onerous solution avoiding bankruptcy (default) costs. The inclusion of the "aggregation" concept, as a way to assure that a super majority could modify "reserve 1 aspects" of the bond is an additional assurance that in a distressed situation all creditors will equally share the burden of a new exchange if the debtor situation deteriorates once again. In other words, “aggregation” means that whilst individual creditors may have less control over their individual series, the higher aggregate threshold gives them greater protection, while lower thresholds for each class prevents other creditors “playing upon “ individual issues. In the proposal, Uruguay's CAC voting thresholds were stringent and based on aggregate principal outstanding amount.
Reserve subjects are i) the money terms, sovereign immunity, governing law, jurisdiction, ranking and mandatory exchange.
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For non-reserve modifications a vote representing 66 2/3 percent is required. For reserve modifications was necessary either to achieve a vote of 75 percent for each series or aggregation criteria- 85 percent for all bonds and 66 2/3 percent of each series. In order to avoid the risk that the issuer could manage future votations,2 new bonds issued in contemplation of a vote and owned or controlled directly or indirectly by the issuer were disenfranchised to participate in a vote. This marked the first time that sovereign bonds included an "aggregation" clause. Also the total replacement of most of Uruguay's debt by a new class of securities points out an exotic opportunity to have aggregation immediately applied to large share of the sovereign debt stock. The Exit consent provisions were the other tool to incentive a cooperative behavior in the exchange. In other words, to put in place some kind of penalties -disincentives- for maverick bondholders. Exit consent was previously used in the Ecuadorian exchange (February 2001) as a lever to induce bond holder's participation and penalize free riding. Uruguay's Exit Consents in some sense were more aggressive than Ecuador's ones. They allowed, i) to carve out the waiver of sovereign immunity from New Bonds payments; ii) to delete the cross default and cross accelerations provisions; and iii) to remove listing requirements. Under these new conditions, the old bonds became automatically subordinated to the New Bonds, becoming less liquid and de-categorized as a common supplier credit. Exit consent provisions became effective if the exchange offer was completed and a 50 percent voting threshold
Mexico's CAC included in a bond issued in March 2003 were critized because left open the possibility that bonds held by the issuer could participate in a vote.
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