The greatest challenge facing Bulgaria during the transition to a market economy is the implementation of appropriate policies to alleviate the debt burden, promote sustainable growth and private sector development.

The privatization and the conversion program can promote each other. Used in combination, they can result in a larger proportion of retired debt through privatization of some of the enterprises that contributed to the debt accumulation. That's why the Debt conversion program should be seen as part of the broader economic policy of the government, including foreign investment.

The right balance among the trade-offs would depend on the particular objectives and constraints Bulgaria has. But it is also important to know how the details of the program are likely to affect the behavior of potential investors in Bulgaria.

At the beginning, the objectives should be basic - to reduce the stock of external debt and use foreign investment as catalyst for faster private sector development

The Bulgarian program should be based on a four-pronged strategy:

1. To speed up privatization

Privatization is a special use of swaps for a buy-out.

A state-owned company is sold to a foreign investor, who pays for it with the local currency generated through a swap transaction. Since the seller is the government, the transaction is not inflationary. In this case swaps are increasing the incentives for the investment and permit the government to retire debt at a discount. In the case of Bulgaria this is the most valuable aspect of the DCP.

The sale prices of the state-owned enterprises are often a controversial issue. The market values are usually below cost. Swaps are helpful in this respect by making foreign investors willing to pay a higher local currency price. The government may enhance the attractiveness of swaps for privatization deals by reducing the amount of the discount it retains for itself. Mexico and Chile had swaps for privatization. In the case of Mexico the debt was redeemed at full face value for investors who applied to use the proceeds to privatize state-owned enterprises. (Argentina expressly forbidden this and Brazil did not allow foreigners gaining control of a Brazilian company).

Argentina's ENTel privatization could serve as important mechanism to be applied in Bulgaria. It was the amount of debt being offered, as opposed to the discount from face value, which was the basis for comparison. Actually, the discount was implicit (based on whatever total valuation each bidder assigned to the equity share being sold), and the explicit selection criterion was the quantity of debt being offered. Since foreign debt is exchanged directly for the shares of the privatized companies, the inflationary effect is not a concern. By using this kind of an auction system, the costly and controversial problem of valuation of shares and assets is avoided. Two-stage procedure of selection was applied. In the first round, potential bidders pre-qualified on the basis of their current operating capacity, efficiency and financial position. In the second round, pre-qualified consortia submitted bids which were evaluated solely on the basis of price. Bids for controlling equity stakes were offered in two parts:

a) a common "base price" in cash US dollars, which all bidders were required to pay; and
b) an "additional price" in external debt which differed among the bidders and was used to determine the winners.

The experience gained so far has provided some guidelines for using debt conversions as an attractive financing tool which benefits both debtor and creditors. The auction system based on volume of debt is an effective alternative to the traditional, costly, controversial and time-consuming valuation of shares. In the absence of a developed capital market, the use of public offering markets and ESOPs to complement private auctions of shares not only contributes to the development of these markets but also allows for privatizations through equity shares.

2. To reduce the external debt

The agreement with the commercial banks has improved Bulgaria's prospects for growth. However, the external debt stock remains at a considerably high level. An active debt management is needed to reduce the debt burden. The DCP could be an excellent instrument for this purpose. Combining accelerated structural reforms with retiring some of the external debt through the program would strengthen the fiscal situation in the medium term. If drastic changes in the capacity to pay and the supply of capital do not take place, Bulgaria's ability to service its debt obligations and to have access to voluntary lending would require longer period of time.

3. To increase foreign direct investments

• The level of incentives to the investors should be kept reasonably high, but a screening procedure should be put in place to eliminate the most obvious non-additional and round-tripping deals.
• The continuity of the program should be maintained over time and the basic thrust of the rules and regulations adopted at the beginning should be followed without changes (of course, if needed, minor changes could be introduced).
• Since all investments made by banks are additional, measures should be adopted to encourage foreign banks' participation. Investment funds financed by swapped debt could be an important mechanism.
• Reasonable timing restrictions on repatriation of dividends and capital are essential.

4. To create favorable business environment

In Bulgaria long term financing for production expansion is not easily available on reasonable terms. In Argentina and to a lesser extent in Mexico this was the case. The local company may use its own foreign exchange to buy the debt because the DCP is acting as an incentive to capital repatriation, as well as a source of industrial financing. In Chile the financial markets are functioning well and a portfolio investment is easier.

A reasonable swap facility can be used not only to transfer ownership of existing companies but also to create new productive capacity.

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