The so-called "swap operations" provide opportunities for discount acquisition of debt instruments on the international financial markets and their exchange for investments at a value equal to the debt obligation.

Such operations became largely popular in Argentina, Brazil, Chile, Equator, Mexico, The Philippines, Nigeria, Venezuela.

Bulgaria is the only country in Central and Eastern Europe to allow the use of foreign debt bonds in privatisation. It is a challenge to introduce a debt-for-equity swap mechanism in a country which is in transition from a centrally planned to a market economy, because of the unique nature of this transition. Of course, it is being carried out based on the considerable experience and analyses of the effect of the debt-for-equity swaps in some countries in Latin America and Africa. The Bulgarian experience is quite modest, since the legal framework of such swaps was enforced only in December 1994. Nevertheless, this short period is sufficient to make an assessment of both the initial and possible effects of the partial exchange of the foreign debt for equity on privatisation. The swap operations are not only a debt management instrument but also an acceleration mechanism for denationalisation.

The current study analyses the positive effects and the problems with the foreign debt exchange as well as their implications for the parties involved in swap operations. Some recommendations based on this study will be made to the policy makers.

CHAPTER I : BULGARIA FACES A SERIOUS DEBT CRISIS

Bulgaria is not among the countries with the largest foreign debt but the parameters of the obligation are quite unfavourable. Unfortunately, the serious debt crisis has been underestimated and this issue was not given priority in the programs of any government so far. The understanding of the seriousness of the crisis is an argument for the introduction of debt-for-equity swap schemes as a possible approach to at least partial reduction of the foreign debt burden.

A standard classification of the World Bank for the 1970-1993 period puts Bulgaria in the group of countries with the largest debt per capita, together with Poland, Mexico, Brazil, etc. All three basic coefficients (GDP per capita, foreign debt/GDP, foreign debt/export) are above the critical level for these countries during the 1991-1993 period. The debt coefficients for 1990-1994 are shown in Table 1, the calculations for 1994 and 1995 being made by the authors of this study.

Table 1

Source: World Debt Tables, Vol. 2, 1994-1995, The World Bank.

Note: Because of lack of GNP data, 1994 coefficients and 1995 forecasts are based on GDP.

The amount of the foreign debt includes the restructured obligations to the London Club, the obligations to Russian and Polish banks not included in the agreement with the London Club, the obligations to the Paris Club, the World Bank, the IMF, and the EU.

The amount of the 1994 interest payments includes buy-back (7.327 mln.), partial payment in the final period (.030 mln.) and down payment (.704 mln.).

The dynamics of the relative foreign debt indicators in the table is related to the deterioration of the economic environment in the country rather than to a considerable increase of the foreign debt. One exception is 1994, when the rescheduling and reduction of the debt on the one hand and the better economic results on the other lead to slightly lower foreign debt/GDP and foreign debt/export ratios.

An analysis of the economic and foreign debt indicators shows that Bulgaria has smaller potential to service its debt in comparison to Poland and Hungary.

Table 2

Economic Indicators, average for 1992-1995.

(in US$ billion)

Source: Salomon Brothers, Emerging Markets Research, Biweekly, April 5, 1995

The abilities of Bulgaria to service its foreign debt are limited, so are the prospects of doing this. In this respect, the inevitable exchange is one of the important mechanisms for relieving the debt burden. In other words, from a fiscal point of view it is justified to have a balanced program for partial exchange of the foreign debt for equity.

The suspicion and the political arguments connected with the swap operations are based on the assumption that the Brady bonds users buy Bulgarian property cheaper and this indirectly lowers the degree of public support for privatisation. This media insinuations do not take account of the direct effect of the exchange on the budget and its indirect influence on the general recovery of the economy. The "lower" price which Brady bonds users pay is offset by the reduction and rescheduling of the debt, i.e. while an individual buyer may profit, the state does not lose. On the other hand, since the swap operations are available to foreign and domestic persons, both of them may profit.

The third fact which is being underestimated by the critics of the debt-for-equity swap in Bulgaria is that it is a part of the debt agreement and in this sense it was a part of the prerequisites for signing of the latter. This means that the scope of the debt-for-equity swap cannot be infinitely limited because this will put under question the conditions of the agreement with all the dangers involved.

Finally, the Bulgarian bonds are not particularly attractive and they have to be made such, which depends to a large extent on the swapping possibilities. As the analysis in Chapter II shows, the prices of the Bulgarian foreign debt are quite unstable and their level suggests that they are not very attractive.

CHAPTER II: FLUCTUATION OF BULGARIAN DEBT PRICES AND FACTORS INFLUENCING THEM

The current Chapter is devoted to the relation between the foreign debt price and the exchange rate as macroeconomic variables indicating the situation and the rates of development of the national economy and comparing them with those of the world economy. If the hypothetical relation between debt price and exchange rate be proven, this will confirm the assumption that in Bulgaria the fluctuation of this macroeconomic factor determines the decisions of the participants on the debt market. On the other hand, the lack of such a relation will lead to the conclusion that the fluctuation of the exchange rate does not influence the price of debt bonds and another variable has to be found to account for the tendency in their change. The validity of the hypothesis will be proven by a descriptive analysis of the dynamics of the exchange rate and foreign debt price.

The analysis begins with an overview of the dynamics of the exchange rate by years. When comparing the fluctuations of debt prices and the USD/BGL rate, the analysed period is further divided into two subperiods, where the natural division line is drawn by the moment of signing of the Brady agreement with the creditor banks, which changes the structure and the levels of the debt price. The exchange rate curves and the levels of the Bulgarian foreign debt for the two subperiods are shown in Chart 1 and Chart 2, while the actual levels are evident from Table 3 and Table 4.

Table 3

(in US cents)

Chart 1

Source: BNB, "Informational bulletin"

Table 4

(in US cents)

Source: PARI Newspaper and reports of ING Bank .

Behaviour of the Bulgarian Debt Price and the Exchange Rate before Signing of the Deal with the London Club Creditor Banks (January 1992 - June 1994)

The exchange rate in 1992

At the beginning of the period the exchange rate was 23.281 BGL/1 US$. For most of 1992 the lev was showing a slight increase. Its devaluation towards the end of the year was insignificant, which is normal for the winter period. In that year the foreign exchange reserves of the Bulgarian National Bank (BNB) increased 4.5 times to reach US$ 1 442.8 mln. at the end of October. The external financing from the IMF accounted for 57% of this increase. BNB had the opportunity to intervene on the domestic market more often, thus supporting the lev high levels. Its policy was facilitated by the lack of sharp increases of forex demand and when such increases were projected (i. e. towards the end of the year), there were sufficient foreign exchange resources for stable market interventions.

The exchange rate in 1993

The BNB policy of flattening out the fluctuations of the exchange rate and gradually devaluating the national currency achieved its goals in 1993. The lev slowly devaluated by 7.13 lv. or 27.9%. In the first half of the year the exchange rate showed almost constant levels. However, for the same period consumer prices jumped by 34.6%, salaries - by 34.8% and the monetary base - by 18.6%. The annual figures for these three indicators are 53.9%, 58.9% and 53.1% respectively. The substantially larger increase of these macroeconomic determinants compared to the exchange rate suggests an active and all-year-round support of the lev by BNB.

The exchange rate in 1994

It is only the forex speculations against the lev, made by market makers on the exchange market, which could account for the sharp fluctuations of the exchange rate that occurred at the end of March and the end of August 1994. Only by April the lev lost 98.3% of its value without any evident macroeconomic reason. Consumer prices rose by just 16.6% and the monetary supply - by 30.7%. So the highly increased demand for foreign exchange was short-term and had a speculative nature. The late intervention of BNB was another reason for the great fluctuations of the exchange rate in 1994.

The foreign debt price levels fluctuated around 16 cents per US$ 1 par value in 1992. They marked a stable downward trend with no sudden falls. Nevertheless, the foreign debt price reached its bottom for the studied period - 13 cents per US$ 1 par. On the other hand, the exchange rate was increasing for the better part of the year, except for the last quarter when the dollar is typically strong. In 1993, the foreign debt price switched from downward to upward trend, with the biggest jump at the end of the year - 57.7%. At the same time the lev suffered from its traditionally big winter devaluation - 16.7%. Only in the first quarter of 1994, the soaring dollar was followed by a reduction of the price of Bulgarian foreign debt. The devaluation of the lev by 98.5%, however, exceeds considerably the 14.6% drop of the foreign debt price. The latest increase of 37.1% came along with much weaker stabilization of the lev in the second quarter. A more likely reason for the debt price jump was the refilling of the foreign exchange reserve by the two IMF loans for total value of $ 185.96 mln.

The hypothesis for a relation between the fluctuations of the foreign debt price and the exchange rate is not supported by the facts for the surveyed subperiod. Furthermore, the trends of these two macroeconomic variables prove to be opposite.

At the end of June, 1994 Bulgaria signed an agreement with the London Club creditor banks for rescheduling and reduction of its foreign debt. Three types of bonds were issued as a result of the deal:

- Discount Bonds (DBs)

- Front Loaded Interest Reduction Bonds (FLIRBs)

- Interest Arrears Bonds (IABs)

This changed the Bulgarian foreign debt position on the international financial markets. It was replaced by three different prices for the three types of debt securities. The movement of the new positions is shown in the next section.

Behaviour of the Bulgarian Debt Price and the Exchange Rate after Signing of the Brady Deal (June 1994 - January 1995)

The three new prices show almost identical dynamics: they fluctuate respectively. Chart 2 shows two of the price levels - the bid price of DBs and FLIRBs.

Chart 2.

The difference between them is almost constant. Therefore, one could talk about a uniform dynamics of the debt price, irrespective of the number of positions. October is a record month for the Bulgarian foreign debt prices. At the beginning of the month they reached their highest: 50.75 cents per US$ 1 par for DBs, 23 cents per US$ 1 par for FLIRBs and 46 cents per US$ 1 par for IABs.

At the same time the lev continued to drop slowly. Its devaluation for the month was 5.6%. From the beginning of that subperiod until the end of October, the devaluation of the national currency compared to the US$ was by 20.9%. For the period November 1994 - January 1995 the debt securities' price continued to decline and reached its bottom on January 11, when the exchange rate was stable, around 66 leva per US$ 1. By the end of the period the rate reached slowly 67.04 leva per US$ 1. The devaluation of the lev for the whole subperiod was by 24.9%, while debt securities lost only 4% of their value. Although gradual, such devaluation shows in a long-term perspective the aggravating situation with the Bulgarian economy and the fact that GDP growth lags behind the increase of the monetary base. In a short-term perspective it is an indicator of a stable, although not drastic overdemand for foreign exchange. The lack of any connection between the exchange rate levels and the foreign debt price confirms the supposition that the isolation of the domestic foreign exchange market from the international ones hinders the way of the signals incorporated in the exchange rate to the international debt market agents.

The problem of having sufficient information and of the interest of the market agent in such information is of crucial importance when analysing the relation between the price levels on a given foreign market and variables connected to the national economy of a country like Bulgaria. The tables and charts deny any connection between the foreign debt price and the exchange rate level and prove that this macroeconomic variable is not taken into account by the debt market agents.

Another indicator, which is not so closely connected with the condition of the Bulgarian economy but because of its nature is well known to the international agents is the amount of the external financing of Bulgaria. Chart 3 shows the relation between external financing and the foreign debt price.

Chart 3

† The debt price after July 1994 is the bid price of Bulgarian DBs.

The pick levels of the debt price are solidly backed-up by the largest amounts of external financing, above all on the part of IMF. The October jump indicates this most clearly. The amount of the foreign support for September and October reached US$ 312 mln. Thus, the improved solvency of Bulgaria is a possible reason for the high levels of the foreign debt price in that period. This is proven by the fact that the actions of the institutions which extend these credits are closely observed by the participants on the debt market.

The empirical data confirms the existence of a cause-and-effect link between external and internal factors and the prices of the Bulgarian foreign debt instruments. The steady increase of the debt price after the principle agreement with the creditor banks is continuing also after the technical conclusion of the deal in July 1994.

The existence of a cause-and-effect link between the debt price on the secondary markets and the governmental changes in the debtor country was proven by the development of the governmental crisis in the country in the middle of November 1995. The drop in the prices of Bulgarian bonds in that period came as a result of the announcement of the premature parliamentary elections. The economic uncertainty before and after the elections made the investment in Bulgarian securities quite risky. Awaiting a new government which would commit to long-term economic goals, the IMF and th