Redifining the Role of the London Club

(A paper prepared for the North South Roundtable on African Debt Relief, Abidjan, Côte d'Ivoire, 8 9 July, 1991.)

By Andrew K. Mullei

Director General, African Centre for Monetary Studies

INTRODUCTION

As a result of persistent poor economic performance and its serious social implications, Africa's debt problem has gained international attention. However, substantive initiatives for debt relief have so far concentrated on official bilateral debt of the low income countries. One assumption has been that commercial debt is still not a serious problem for African countries. While it is true that Africa's debt problems relate primarily to official debt, the commercial debt outstanding for some African countries is stiffling with debt service increasing rapidly. For a number of countries, including Côte d'Ivoire, Morocco, Nigeria, the servicing of commercial debt absorbs more than 15 per cent of export earnings.

In the face of mounting commercial debt service, many African countries have sought bank (London Club) restructurings in addition to those of the Paris Club. While the commercial debt restructurings have provided temporary respite to the debt service burden, they have not solved the debt problem except to push it forward year by year and to increase the frequency of negotiations, which absorb a great deal of skilled manpower, already scarce in African countries, while also adding to uncertainties concerning future financing. Admittedly, in recent years, certain positive proposals have been made to help reduce the burden of commercial debt service and to encourage new money flows from the banks. However, so far these initiatives, which could also benefit African commercial debtors, have been applied mostly to the Latin American debtors, obviously with the active collaboration of the creditor banks. It is the view of this author that the banks can play a similar positive role in applying the new initiati

ves to solve the African commercial debt problem, provide new money to the region and support the ongoing rigorous structural adjustment programmes.

THE APPROACH OF THE LONDON CLUB

Until the mid 1970s, difficulties of debtor countries in servicing their private (or commercial) debts were met by refinancing arrangement (i.e. the provision of new funds to service existing obligations). This arrangement for resolving difficulties of debt repayment was convenient at the time to both the commercial banks and debtor countries. Refinancing was provided under the terms of the original agreement and, therefore, enabled the banks to maintain the loans in their books as performing. To the debtor countries, refinancing did not have the stigma of rescheduling and, therefore, preserved their creditworthiness as well as the bank's exposure. Refinancing was, however, convenient and possible as long as the number of banks and countries involved was small. Thus, as the number of countries facing debt difficulties increased in the mid 1970s, refinancing became no longer appropriate. The creditor banks were, therefore, compelled to reschedule (i.e. change the contractual terms of repayment) to give

the debtor countries greater manouvability in their adjustment plans. The London Club, therefore, evolved as a forum for rescheduling debts owed to commercial banks on a case by case basis.

The London Club, unlike the Paris Club, has no formal framework for conducting commercial bank reschedulings. However, over the last few years, certain procedures have been followed and most reschedulings have been undertaken in a fairly similar way. The number of creditor banks for any particular debtor country may be so many (in some cases numerous) that all of them cannot possibly and conveniently participate in the negotiations. The negotiations are, therefore, handled by bank advisory (or steering) committees, comprising normally of the banks with the greatest exposure to the country but consideration is now given also to geographical spread in order to properly reflect the variety of banking procedures and regulations and to facilitate communication with the banks involved.

The Bank advisory committees serve several convenient purposes. While enabling the debtor country to hold discussions with only a few key banks rather than a multitude of banks, they permit the negotiation of a multilateral rescheduling agreement with all of the country's commercial bank creditors, ensuring that no creditor has more favourable treatment than another. In this regard, the committees encourage all banks, particularly those with limited exposure, to associate themselves with the agreement. In addition to rescheduling (or refinancing) on medium to longterm basis, the bank advisory committees also facilitate the maintenance of trade credits and other short term exposures. The committees also provide a point of contact for multilateral organisations, particularly the IMF and the World Bank. They also provide a framework within which the banks can monitor the performance of the debtor country's external payment problems.

A typical agreement from the Londong Club negotiations covers the required debtor country's adjustment programmes, the debts concerned, the consolidation period, the cut off date, the percentage of principal and of interest rescheduled, the treatment of arrears, the grace and repayment periods, and other legal issues. However, since the mid 1980s, the London Club rescheduling process has been refined in certain ways partly to accommodate debtor countries' complaints but also in response to changing attitudes of the international community towards developing country debt.

Broadly speaking, four major players have contributed to the refinements : the multilateral financial institutions, the governments of the creditor banks, the debtor countries and the commercial banks. The IMF has played a vital role by introducing longer adjustment programmes to which the consolidation periods of the agreements are linked. The Fund and the World Bank have also encouraged the London Club by relating their disbursements to commercial bank rescheduling and, where appropriate, new money. The governments of the commercial banks have encouraged the London Club to adopt a multi year rescheduling mode. At the Paris Club, the governments have also introduced rehabilitation packages for official debts being rescheduled, thus encouraging the London Club to make efforts in the same direction. The debtor countries have also persevered with rigorous adjustment programmes and improved their management of external debt which have helped relations with creditors. The banks have also improved their por

tfolios, thus becoming less anxious about developing countries' debt.

While the earlier reschedulings were shaped rather like syndicated loans three years' grace, four years' amortization, rescheduling fees paid at the front end, wide spreads, limited currency options, less than 100 per cent of principal rescheduled and refinancing of interest recent reschedulings have longer amortization: seven to eight years, reduced fees and spreads, and often rescheduling of the total amount of principal falling due during the consolidation period. Also, multi year (3 to 5 year) consolidation periods have replaced the earlier shorter ones. It is a view of this author that despite the refinements, the London Club agreements do not still provide a useful framework for assisting the debtor countries to overcome their financing difficulties.

THE CASE FOR FURTHER REFORM OF THE PRESENT FRAMEWORK

The international community has now accepted the point that current rescheduling packages are essentially designed to postpone rather than reduce the burden of bank debt servicing. Although the arrangement has created time for the international system to avoid default by big borrowers, the advantage of the short term respite is far outweighed by the significantly increased debt servicing obligations, involving a heavy "bunching" of amortization payments after the grace period expires. Many debtor countries have had to return at regular intervals for repeated negotiations, in certain cases with a re rescheduling of maturities already scheduled. The repetitive negotiations have, however, failed to assist the countries to return to uninterrupted debt service or avoid accumulation of arrears. At the same time, they have introduced uncertainties on the profile of debt service and new financial flows, making it difficult for debtor countries to undertake long term policy reforms.

The advantage of rescheduling the principal and refinancing interest has had certain drawbacks in the sense that it hinges on the flow of involuntary lending (or new money) from the banks and the ability of debitors to meet interest payments as well as their implementation of structural adjustment. So far, the evidence indicates that this strategy (as well as initiatives like the Baker Plan, which were based on it) has not worked even for the Latin American debtors on which international attention has focussed much less the African market borrowers. This approach has failed to work because with each renewed attempt of renegotiation, marginal banks decide to withdraw and major banks also run up against exposure limits : hence, the difficulty of ensuring that all existing lenders participate pro rata. This difficulty is buttressed by the often bleak prospects of the debtor countries' ability to grow out of the debt trap under the current framework and the fact that in the capital markets developing count

ry debts are trading at deep discounts to their face value. In such circumstances, commercial banks become unable to account for new loans as assets in their books when they are disposing of their exposures to the same countries at less than 100 per cent of face

value. Besides, regulations which require that additional reserves be established for new loans to debtor countries add to the cost of participating in a new money facility, reinforcing the banks' unwillingness to provide new financing.

A third worrisome aspect of the current arrangement in the London Club is the practice by commercial banks to maximise short term returns on rescheduled debt by charging penalty lending margins and arrangement fees for debt rescheduling in contrast to the practice followed in many domestic debt restructurings, which provide for somewhat reduced lending rates to help a borrower back on his feet. While the banks might have been making money from the high charges, the advantage to them is illusory in the long run as the charges have only added to the financial difficulties of the debtor countries, undermining their ability to become solvent.

A fourth disadvantage with London Club rescheduling is that the terms and practices are still fixed almost regardless of different capacities to pay. The smaller and economically weak debtor countries in particular, have little opportunity to moderate upward interest rate adjustments, fees and other commissions on rescheduled debt and have rarely been accorded grace and repayment periods appropriate to their capacity to pay. This is especially the plight of African debtors, which unlike those in Latin America, do not have huge debts that pose systemic risk and, therefore, for which the major banks can afford to discount the risk of default. Many African borrowers have, therefore, been compelled to service their debt by compressing imports and investments, which hampers their growth potential. In addition, international transfer problems in many heavily indebted African countries have increased as larger shares of revenues are being devoted to debt servicing. In many of these countries, opposition to

maintaining full debt service has arisen since the costs of debt service are high, immediate and obvious, whereas the benefits appear remote and uncertain.

There are many other reasons why the case of African commercial debtors deserve special attention by the London Club. Many of them have accumulated arrears on trade credits, resulting in extremely damaging interruptions of their short term lines of credit. The "clearing up" of these arrears is a high priority for the African debtor and one for which the London Club could play a positive role. In the African context, a strong case that can be made in redefining the role of the London Club is that foreign investors are extremely skeptical or most African countries' prospects for the rest of the century. Therefore, the prospects for extensive voluntary debt equity swaps, which could reduce outstanding debt, are not very bright. At the same time, the foreign exchange reserves and state revenues of African governments are typically too low to permit their use for buy backs of the external debt.

POSSIBLE NEW INITIATIVES BY THE LONDON CLUB

In the above discussion it is indicated that the London Club arrangements focus on solving liquidity problems of the debtor countries and even so in an inefficient manner. For many African countries, the debt problem has worsened beyond one of liquidity (ability to pay now) to that of solvency (ability to ever pay off). While it might be suggested that a debt problem of a liquidity nature could be contained through temporary reductions in expenditure, through debt restructurings to stretch out payments, and/or the disbursements of new loans to roll over the payments falling due, insolvency of the African countries would require debt write-downs to bring repayments to sustainable levels. In this connection, any effective role for the London Club would need to allow for debt reduction. Jeffrey Sachs, in a recent World Bank Working Paper Series (entitled 'Efficient Debt Reduction'), has argued strongly and correctly that "instead of 'voluntary' debt reduction, we need a 'concerted' debt reduction" scheme

involving a programme worked out by the debtor country in collaboration with international financial institutions and the creditors to restructure and reduce its debt. Two of such schemes that appear to have prospects of wide and popular acceptance are the World Bank Debt Buy Back Facility and the Brady style Menu Based Concerted Debt Reduction. The former, set up in early 1990 with a limited fund of $. 100 million, would assist IDA eligible countries to buy back their debt at a significant discount, so that the debtor cashes in on the secondary market discount. This facility, while commendable, it addresses the problem of the commercial bank debts of only low income countries, most of which are in Africa. Conceptually, African countries can collectively push for its extension to cover also the problem of the middle income African countries but arguing a case for such collective action is beyond the concern of this paper.

It is the opinion of this author that commercial debt reduction of middle income African countries could also be achieved through a Bradystyle menu based concerted debt reduction. The main elements of the initiative announced by the U.S. Secretary of Treasury, Mr. Nicholas Brady, in March 1989, are : (a) the reduction in principal and/or interest of external debt owed to commercial banks; (b) the selection by commercial banks and the debtor country of the exact modality of debt reduction from a menu of options including buy backs and debt equity swaps at deep discounts, debt for bond swaps at lower interest rates, debt securitization at significant discounts; (c) the adoption of recommendations on regulatory and accounting changes in home countries to facilitate commercial bank participation in the plan; and (d) the provision of IMF/World Bank guarantees to encourage banks to participate in the debt reduction plan.

While the concerted debt reduction approaches require the joint efforts of host governments, multilateral financial institutions, debtor country governments and creditors, for the commercial banks there can be a "free rider" problem. A successful debt reduction deal would normally lead to an increase in the secondary market price of the remaining debt stock, thus awarding creditors who hold out of the scheme a capital gain at the expense of those creditors who voluntarily participate in the Scheme. There would exist, therefore, a disincentive for creditor banks to participate in such schemes even if they perceive them to be in their own interest as well as in the debtor's interest.

By supporting the subjection of non participating banks to a cost for holding out, the London Club can assist in eliminating the free rider problem of the concerted approach and thereby enhancing its efficiency for debt reduction. As was done in the case of the Costa Rican debt reduction deal, the London Club can also take further advantage of their leverage factor by building into the scheme a process that turns the potential cost to holding out into a benefit to the debtor. The Costa Rican deal required creditors that exchanged less than 60 per cent of their debt to provide new money, with the new debt instrument likely to be discounted back to the secondary market price. This discount in the secondary market is immediately appropriated by the debtor.

The role of the London Club might even be more crucial for a multilateral institution supported debt buy back scheme, such as is set up at the World Bank. The very rumour of an intention of such a buy back tends to cause secondary market prices to shoot up, effectively wiping out the discount and annihilating the utility of the deal. This disabling effect can be eliminated by a concerted participation of the London Club with the other participants in the scheme. To be effective the concerted participation of the London Club would, of course, need to be flexible by giving creditor banks' choice to participate in a particular kind of debt reduction (e.g. debt equity swap, debt for bond swaps, debt buy back or debt securitization) and debtor countries the opportunity to participate in the design of the scheme to suit their particular circumstances and preferences.

The new role of the London Club in supporting concerted debt-reduction deals would not, however, make its role in rescheduling debts obsolete. In fact, after debt reduction schemes succeed in bringing down the debt stocks to levels that are consistent with debtor countries' capacity to pay, rescheduling would still be necessary to meet liquidity problems of debtors countries. In that regard, the London Club could play a useful role in evolving a realistic framework for debt rescheduling that effectively resolves the liquidity problems of debtor countries without imposing losses on the banks. Such a framework would include, for example, stretching out of amortization and capitalisation of interest.

In effect, a new and effective role for the London Club in resolving the debt crisis of African countries would have to be eclectic in character, by dealing simultaneously with the debt overhang problem, for new lending, and the necessity to strengthen the international banking system and safeguard against the possibility of deep financial losses. However, that new role would also have to be defined with the encouragement and support of the multilateral institutions, the governments of the creditor banks and the debtor countries all of which, together with the commercial banks, have been key players in the past for bringing refinements in the approaches of the London Club.