WDP-76

76 E World Bank Discussion Papers

Debt EquityConversion Analysis

A Case Study of the PhilippineProgram

John D. Shilling,Anthony Toft,Woonki Sung, andWayne Edisis

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7 6 World Bank Discussion Papers

Debt EquityConversion Analysis

A Case Study of the PhilippineProgram

John D. Shilling,Anthony Toft,Woonki Sung, andWayne Edisis

The World BankWashington, D.C.

Copyright C 1990The World Bank1818 H Street, N.WWashington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing March 1990

Discussion Papers are not formal publications of the World Bank. They present preliminary andunpolished results of country analysis or research that is circulated to encourage discussion andcomment; citation and the use of such a paper should take account of its provisional character. Thefindings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) andshould not be attributed in any manner to the World Bank, to its affiliated organizations, or to membersof its Board ofExecutive Directors or the countries they represent. Any maps that accompany the texthave been prepared solely for the convenience of readers; the designations and presentation of materialin them do not imply the expression of any opinion whatsoever on the part of the World Bank, itsaffiliates, or its Board or member countries concerning the legal status of any country, territory, city, orarea or of the authorities thereof or concerning the delimitation of its boundaries or its nationalaffiliation.

Because of the informality and to present the results of research with the least possible delay, thetypescript has not been prepared in accordance with the procedures appropriate to formal printed texts,and the World Bank accepts no responsibility for errors.

The material in this publication is copyrighted. Requests for permission to reproduce portions of itshould be sent to Director, Publications Department, at the address shown in the copyright noticeabove. The World Bank encourages dissemination of its work and will normally give permissionpromptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permissionto photocopy portions for dassroom use is not required, though notification of such use having beenmade will be appreciated.

The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list and indexes of subjects, authors, and countries and regions; it isof value principally to libraries and institutional purchasers. The latest edition is available free of chargefrom Publications Sales Unit, Department F, The World Bank, 1818 H Street, N.W, Washington, D.C.20433, U.S.A., or from Publications, The World Bank, 66, avenue d'1ena, 75116 Paris, France.

John D. Shilling is manager of, and Anthony Toft and Woonki Sung staff members of, the FinancialAdvisory Unit of the World Bank's Cofinancing and Financial Advisory Services Department; WayneEdisis is with the Foreign Investment Advisory Services of the Intemational Finance Corporation andMultilateral Investment Guarantee Agency, both affiliates of the Bank.

ISSN 0259-210X

Library of Congress Cataloging-in-Publication Data

Debt equity conversion analysis : a case study of the Philippineprogram / John D. Shilling ... let al.].

p. cm. -- (World Bank discussion papers ; 76)ISBN 0-8213-1515-31. Debt equity conversion--Philippines. 2. Debts, External-

-Philippines. 3. Loans, Foreign--Philippines. I. Shilling, JohnD., 1943- . II. Series.HJ8802.D42 1990336.3'4'09599--dc2O 90-34372

CIP

ABSTRACT

The paper analyzes the potential impact of implementing a debtequity conversion program on selected macroeconomic variables of adebtor country and discusses some pragmatic issues related to theimplementation. It shows that benefits of conversions, primarily thepromotion of additional investment and debt reduction, may come withshort-run costs in monetary expansion carrying inflationary potential.But it demonstrates that these costs are more than offset by reductionsin monetary expansion and lower service payments over the followingseveral years due to the debt reduction. The paper suggests that shouldthe government decide to establish a program, it integrate the likelyeffects conversions into the overall macroeconomic planning.

In regard to the implementation of a program, the paperdemonstrates that various mechanisms can have a great effect on theprogram's efficiency in meeting its objectives, and that the best way topromote additional investment would be to maintain a steady program ofsufficient duration.

This paper was written by Messrs. John D. Shilling, Anthony Toftand Woonki Sung of the Financial Advisory Unit of the Cofinancing andFinancial Advisory Services Department, World Bank, and Wayne Edisis ofthe Foreign Investment Advisory Services, IFC/MIGA whose involvementwas funded by UNDP under Project INT/87/021. The views andinterpretations in this document are those of the authors and shouldnot be attributed to the World Bank, its affiliated organization or toany individual acting in their behalf.

TABLE OF CONTENTS

Page No.

I. Introduction ............................................ 1

II. Analysis of Debt Equity Conversion ..................... 3

Objectives and Trade-Offs .. 3Investment Promotion .. 4Macro-Economic Impacts .. 6a. The Burden of the Debt and Conversions. 6b. Potential Inflationary Impact. 8c. Impact on the Balance of Payments .................. 15d. Integrating the Debt Equity Swaps

into the Macro Plan .19e. The Asset Privatization Program .20f. Aggregate Effects .23

III. The Mechanics of Debt Equity Conversions .24

Measures to Increase Additionality .24Approval Process and Auction System .26Preventing Round-Tripping .30

IV. Conclusion .32

ANNEX

I. Analysis and Projections of Macro-Economic Impacts

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I. INTRODUCTION

1.01 In the course of the continuing debt crisis, a number of highly-indebted countries have initiated debt equity swap programs. Among them,Chile, Mexico, Brazil, Argentina and the Philippines have implemented moreactive programs than others. These countries aimed to achieve severalobjectives through their programs. Recently, however, some of thecountries restricted substantially or suspended the programs primarily onthe grounds that, as they perceived, conversions would entail macroeconomiccosts and provide unjustified subsidies to foreign investors.

1.02 In a typical debt equity conversion deal, an investor, foreign ornational, purchases title to a foreign currency-denominated debt at adiscounted price on a secondary market. The investor then presents thistitle to the government authorities in the country which originallycontracted for the loan. The national authorities next issue the facevalue in local currency to the investor, a portion of which may be retainedby the government as a means of capturing for itself part of the secondarymarket discount. Finally the investor spends the local currency toimplement an approved equity investment project.

1.03 Debt equity conversions provide a debtor country with anopportunity to prepay its foreign debt at a discount within the frameworkof debt restructuring agreements and to promote foreign investment througha preferential exchange rate. The conversion creates a cash bonus for aninvestor equal to the difference between the secondary market price (whichrepresents the investor's expenditures) and the redemption price receivedafter the government takes its share (which represents the investor'spayout). The bonus can be effective for attracting new foreign investment.Conversions can also facilitate public service restructuring programs, suchas privatization programs, channel investment funds to priority sectors,and encourage the return of flight capital. However, debt equityconversions are a double-edged sword. Depending on the structure of thedeals, they may have macroeconomic costs, primarily adverse monetary/inflationary and balance of payments effects.

1.04 The paper critically analyzes the potential impact of implementinga debt equity program on selected macroeconomic variables of a debtorcountry and discusses some pragmatic issues related to the implementation.The analysis is "partial" in the sense that it is not based on a full macromodel of the economy. Nor does it try to "solve" for optimum values of themajor macro economic variables. An important element of the analysis isplacing a conversion program in a medium-term framework to identify thelonger term impacts, positive and negative, on debt and payment flows,rather than just the first year effects. It highlights the

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trade-offs that decision makers will have to weigh if they decide to have aprogram. The approach in the paper is generic in the sense that the mainelements of the analysis can be generally applied to conversion programs ofa number of debtor countries although its analytical focus is primarily onthe Philippine conversion program. l

1.05 The outline of the paper is as follows. Section 2 discussesseveral objectives that can be achieved through a conversion program andpossible trade-offs among the objectives. It investigates how a programpromotes investment. This is followed by an analysis of macro-economicimpacts including debt reduction, potential inflationary and the balance ofpayments effects. Section 3 reviews the mechanisms of debt equityconversion processes and suggests ways to increase their effectiveness. Inparticular, it addresses several measures to improve additionality, theapproval process, the auction system and safeguards against abuses ofconversions. Section 4 concludes. The annex has projections of macroeconomic impacts of conversions.

1I The Philippine conversion program was announced through Central BankCircular No. 1111, 1986 Series, Program for the Conversion of PhilippineExternal Debt Into Equity Investments, of August 4, 1986 (the Circular).

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II. ANALYSIS OF DEBT EQUITY CONVERSION

OBJECTIVES AND TRADE-OFFS

2.01 A debtor government could have several objectives to achievethrough a debt equity conversion program. The stated objectives of thePhilippine program, for example, as stipulated in Central Bank Circular No.1111 are: to promote foreign investment, to encourage the repatriation offlight capital, to promote investment in priority sectors, and to reducethe external debt burden. Although the program can contribute to achievingall of the objectives, there may be conflicts among them in that achievingone may affect the capacity to achieve others. There are trade-offsbetween using conversions to stimulate investment and to retire foreigndebt. Further, while all conversions entail macroeconomic costs, primarilyadverse balance of payments and monetary/inflationary effects, thestructure of a program has a bearing on the nature and magnitude of thecosts involved.

2.02 If the government wishes to achieve primarily debt reductionthrough conversions, its conversion program should be structured to beflexible in screening and processing conversion projects. It shouldencourage a large volume of conversions for investment, additional or non-additional, and capture a large share of secondary market discounts for thegovernment. The larger a portion of the market discount that thegovernment captures, the more it can reduce its liabilities for a givenexpenditure, but the less of the discount will be left to stimulateadditional investment. As a result, a large volume of debt may be retiredbut less additional investment may be promoted, and conversely. The lessadditional investment that occurs, the greater will be the short term drainon foreign exchange revenues, although this decline will be reversed in themedium term due to savings on future debt service payments.

2.03 On the other hand, if the primary objective of a program is topromote additional investment, then a larger share of the discount may needto be left to the investor and the program made more selective. To theextent the program is effective in promoting investment, there will beadded benefits to the economy from the higher level of investment thanwould occur without the program. The government is likely to capture lessof the discount, but the initial adverse effects on the balance of paymentswould be less than with little additionality. Depending on specificassumptions, the impact on the creation of reserve money will be favorableabout the same, but the government will retire less debt per unit ofexpenditure if it increases the bonus to raise additionality. If a programwere geared too strongly toward additionality, it would run the risk thatthe conversion volume would remain too small, with much lower impact ondebt reduction.

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2.04 If a program is predominantly oriented to the promotion of foreigninvestment in priority sectors, it may help channel investment funds to theprivileged sectors, which would not occur in the absence of the program.However, as experienced in some countries with a special program in placefor incentive projects, enthusiasm for investment in priority sectors withlow profitability may turn out to be difficult to sustain, even with asubstantial exchange rate bonus to the investor. If this were the case theresult could be an inactive program with insignificant amounts of foreigninvestment promoted and foreign debt retired, very large subsidies toinvestors participating, and the government capturing a very small, if any,portion of the discount. The potential for inefficiency resulting fromsuch distortion is also large.

2.05 If the repatriation of flight capital is the primary objective, aprogram can be structured to provide a de facto amnesty to nationalinvestors to encourage the return of funds previously sent abroad. Whilethere may be some political considerations to be taken into account, thisprocess of using flight capital reflows to retire foreign debt through theswap program has a more favorable impact on the balance of payments becausethey are least likely to generate future transfer streams abroad.

INVESTMENT PROMOTION

2.06 Additional Investment Although investors are not greatlyinfluenced by post investment benefits, such as tax incentives, they tendto respond favorably to pre-investment advantages, such as the bonusgenerated by a debt-equity conversion. This is because investor areassured of receiving "up front" the full benefit of the bonus.Particularly, the bonus both lowers risk by reducing the total investmentexpenditure and heightens reward by creating a better rate of return. Ananalysis of conversion programs in Chile, Argentina, Brazil and Mexico hasdemonstrated the appeal of this bonus; it was estimated that over 602 ofall debt-equity investments were 'additional" -- due to the existence ofthe program.1 However, it appears that additionality under the Philippineprogram has been low compared with the experience in Latin America. Inother words, many of the investments made through debt equity conversionswould have occurred anyway.

1/ Debt/Equity Swaps and Foreign Direct Investment in Latin America,J. Bergsman and W. Edisis, IFC Discussion paper Number 2, The WorldBank, 1988, p. 8. In this paper, additionality is defined as meaningthat the particular investor would not have made the investment if aswap were not available. Partial additionality means that somethinglike the investment would probably have happened sometime without theswap, but that the swap made the investment happen sooner and/or madeit larger.

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2.07 The low additionality under the Philippine program to date shouldnot be surprising. Most investment projects of consequential scale,especially when undertaken by foreign investors, require more than a yearof advance planning. Consequently, an 'incubation period' is necessarybefore a conversion program can begin to attract substantial additionalinvestments. The Philippine program using Central Bank paper was stopped,however, before many investors were past this critical time. Thus, most ofthe investment undertaken with CB swap program may have not been additionalin the strict sense. It does appear that the program has contributed tomaking the size of the investment significantly larger than otherwise wouldhave been the case, inducing new technologies or advanced equipment, andadvancing the timing of foreign investment.

2.08 The conversion program may have produced other more importantbenefits to the Philippines. Its existence created confidence in the newGovernment's determination to restore a vigorous investment climate and tomanage the country's large outstanding debt. In fact, when a country suchas the Philippines emerges from a crises period, it may be useful to grantinvestment incentives without worrying about free-riders. The program doesappear to have played a role in the overall recovery of private investmentin the Philippines. Net foreign investment in the Philippines rose fromthe level of $17 million a year in 1984 and 1985 to $140 million in 1986when the program was announced, $205 million in 1987 and $500 millionduring the first nine months of 1988. Out of $705 million investmentrecorded during the period of 1987 and the first nine months of 1988, over$640 million worth, representing 781 of the investments, was transactedthrough debt equity conversions.

2.09 Debt Reduction and Priority Investments. As of August 30, 1988debt-equity conversions under the program retired the external debt of thePhilippines in the amount of $660 million, representing about 62 of thecountry's debt owed to commercial banks eligible for conversion. Of the$660 million, about 902 involved Central Bank paper, with the balanceinvolving private sector debt (92) and non-CB public sector debt (12). Asa result, the country's interest payments will be reduced by approximately$70 million annually, assuming LIBOR of 9.5Z, which represents about 62 ofthe total interest payments to commercial banks. Of the conversions dealsclosed, about 502 with a value of $259 million as of September 30, 1988were concluded by local investors. Although it is difficult to quantify, amajority of these national investors appear to have repatriated flightcapital through the program. Of the transactions closed, 942 of the totalvalue were Schedule 2 investments in priority sectors, with exportproducers, assets for privatization, and agricultural producers leading thelist.

2.10 The perceived adverse monetary and inflationary effects have beena limiting factor for the Philippine program. However, the impact ofconversions on inflation is a very complex issue requiring careful reviewof other factors leading to inflation before any firm conclusions can bedrawn. These macroeconomic issues will be discussed in the next section.

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MACROECONOMIC IMPACT

(a) The Burden of the Debt and Conversions

2.11 The debt equity swap program offers a debtor government theopportunity to reduce, at a discount, the absolute amount of debt that theeconomy has to service, to convert a portion of the fixed term externalliabilities (debt) into contingent liabilities (equity), and to transfersome of the repayment liability from the government/Central Bank to theprivate sector while at the same time promoting private investment.Retiring debt at a discount has a high yield. In the case of thePhilippines, in comparison to the payments stream under the currentrescheduling, prepaying the debt at a 30% discount over face value yields arate of return to the economy of about 22Z in current dollar terms. A 40Zdiscount yields 27Z rate of return.2 The difference between these discountsand the secondary market discount of about 50X of face value is the bonusthat accrues to the investor. Central Bank debt swaps, if carefullydesigned, can generate cumulative gross savings on balance of paymentsoutflow of about $250 million during 1989-93 per $100 million per year unitof debt retirement.3 In addition, swaps of government debt in the AssetPrivatization Trust (APT) program will have a net positive impact on thegovernment budget within two to four years and generate an internal rate ofreturn to the budget of 40X or more.

2.12 The costs of the program are, depending on the type of swapsundertaken, the requirement to generate local currency resources to prepaypart of the debt being swapped, the increase in foreign ownership of realrather than financial assets in the country, the additional demand forforeign exchange in the short run,4 and the possibility of fraudulentgains. The relative weight of these benefits and costs will be analyzedbelow for the principal kinds of swaps being considered in the Philippines.

2.13 There are generally three types of debt in the Philippines thatcould be used for swaps, and each has different characteristics and impactson the macroeconomic equilibrium. Debt owed by private debtors may beswapped for equity of non financial private sector firms or prepaid. Theprimary effects are on the balance sheet of the debtor, who may reap a bonusfrom part of the secondary market discount; on the ownership and managementof the debtor if equity is transferred; and on the net foreign exchange

2/ These rate of return calculations assume the Philippines willeventually repay the full value of its external debt.

3/ Counting DFI foregone in addition to savings on other flows gives apositive total cumulative impact in the sixth or seventh year,depending on other assumption.

4/ Including DFI flows implicitly used for debt prepayment and use ofreserves for capital imports.

position of the banking sector, which will be higher over the term of theretired debt by the amount of the discount.5 The government has recentlydirected most proposed swaps to private debt to avoid the inflationaryimplication of using Central Bank debt. As a result of this increaseddemand in relation to a relatively small stock of debt, there is littleprivate paper available in the market, and the discount has been sharplyreduced.

2.14 Debt owed by the central government under current regulations maybe converted and used in the purchase of public assets being privatized.Although this conversion is analytically the swap of a debt instrument forequity and thus a balance sheet transaction with no budgetary implications,the actual mechanism makes it more complicated. The prepayment of the debt(at a discount implicit in the 30Z fee charged by the government) is treatedas a line item expenditure in the government budget. The investor then usesthe funds received for the debt surrendered to pay the government for theassets he is purchasing. This payment is entered as a revenue item. Thetransaction is a wash as far as the current budget balance is concerned andhas no direct inflationary impact, but the amount of swaps possible isdetermined by the budget allocation to that line, which is set by thelegislature in the annual budget.6 After the swap, the government is nolonger responsible for servicing that debt, which is extinguished. Theprivate investor, if a foreigner, will service the equity liability throughrepatriation of dividends and eventually his capital, so there remains afuture claim on foreign exchange, but not on the government budget. If theinvestor is a national, there is no further specific right or expectation toexpatriate earnings or capital, and the foreign exchange obligation is alsocanceled. To the extent that the capital account is open, the Filipinoinvestor would have the same right of any Filipino to convert Pesos intoforeign exchange in the future.

2.15 Debt owed by the Central Bank may be converted into domesticcurrency for approved investments or into peso denominated debt instruments.The Central Bank has no physical assets to convert and must issue fiduciaryinstruments (cash or bonds). This is potentially the largest part of theswap program. This program has been temporarily suspended due to the highlevel of demand and the concern over the inflationary impact of the domestic

5/ To the extent that private firms can arrange to prepay their debt intranches just prior to the maturity of each payment, they benefit fromthe discount and must do very little prepayment. This however requirescomplex intermediation from the banking sector as well.

6/ There is often a temptation to count revenues from asset sales as asource of current income in the budget. While technically possible, itis not usually wise since it is not a permanent source of income and inthe absence of full asset accounting, tends to offer a misleadingpicture of government financing since the net decline in public wealthis not recorded. Swapping assets for debt, however, enhances publicnet wealth by the amount of the discount. And the fee thus generatedcan be used as exceptional income.

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currency that must be issued by the Central Bank to redeem the debt beingswapped. Resources to prepay the debt must be generated by revenue raisedby the government, by credit expansion, by money creation, or by issuingCentral Bank debt in the local market. The first has an impact on thebudget deficit, the next two on inflationary pressure, and the last ondomestic capital markets, which are already pressed by the financingrequirements of the government budget. These possible effects will beanalyzed below.

(b) Potential Inflationary Impact

2.16 When external debt is used directly to acquire domestic physicalassets (private or government debt for assets), equity of the debtor(private debt for equity), or peso debt of similar or longer maturity(private or Central Bank debt for debt), there is no current element of thetransaction to increase domestic demand or to expand money and credit. Thusthere is no direct inflationary consequence. Even in the case where aprivate debtor prepays his debt in cash to an investor who then acquiresother assets, there is not likely to be an increase in demand unless overallcredit to the economy is allowed to expand to finance that transaction. Theliquidity is generally transferred from the debtor to the investor. In thecase of debt-for-debt swaps, however, when there is substitution of adomestic creditor for a foreign creditor, this may put pressure on domesticcapital markets. In the case where the Central Bank retires its debt byissuing cash to be used for investment, there a potential inflationaryimpact. In view of the potential amount of these swaps, this issue deservescareful consideration.

2.17 The extent to which the monetary creation7 resulting from the swapsof Central Bank paper translates into inflation depends on several factors:the inflationary momentum, other demands for monetary expansion (e.g. thesize of the consolidated government deficit or private loan demand), thedegree of excess capacity in the economy, and the supply response ofincreased production and exports from the investment. The issue is anintertemporal one. The resources would have to be generated to purchase theforeign exchange to pay interest currently and later to pay amortization onthe external debt when it falls due in 1993 and thereafter. The question isto what extent the economy can absorb the impact of generating the resourcesnow (for retiring debt at a discount) or must postpone that until later (torepay at full value). As will be demonstrated below, the total netrequirement to create additional money, or equivalent, is the same over a 6year period for a swap program or for normal debt servicing; only the swapprogram front loads the monetary expansion. The internal rate of return tothe Central Bank's budget of the swap would be 22-27Z, if the resourcescould be found to initiate the program. The net resource requirementdeclines after the first year.

7/ Budget financing would increase the deficit, and that would eventuallyrequire Central Bank financing in the current economic environment,with similar impact.

2.18 An analysis of the potential inflationary impact must take placein the context of the macroeconomic planning that sets growth and inflationtargets within a consistent framework. That planning process must weigh avariety of factors, costs and benefits of alternative strategies, and thepossible effects on expectations and levels of confidence in thegovernment's program. The size and format of a debt equity conversionprogram is but one, relatively small, element in that planning process.Judgements about its potential utility over time might justify somemodifications in the overall macroeconomic targets, but the swap programcannot drive the other targets. What is important is that the program beintegrated into the multi-year macroeconomic framework, which is taken uplater.

2.19 The actual impact on inflation will depend, of course, on otherdemands on credit creation. The most important of these is the expectedsize of the consolidated government deficit and its financing. The largerthe level of credit or monetary creation required to finance the governmentdeficit, the less that would be available for the prepayment of debt througha swap program within any overall target on credit expansion. Thegovernment deficit may also be financed by domestic or foreign borrowing.This would reduce the need for monetary creation, but would put pressure onthe domestic capital market or strain the limits of the governments accessto foreign resources. The size of the government deficit has beeninfluenced by the recent political changes and the restructuring of majornational development banks and public enterprises. As the impact of thesefactors is absorbed and passes, the government will be able to exercisegreater control over the deficit and its financing.

2.20 To integrate a debt equity swap program into the macro framework,the government must weigh its impact on base money and the money supply, onsupply and demand conditions in the economy, and on the credit markets.Resources for the swap can come from increased revenues, monetary expansion,or public sector borrowing. Use of either current revenues or monetaryexpansion definitively retires debt and yields a higher rate of return thanborrowing, which still leaves the government with a debt servicingliability, albeit only in local currency. Assuming revenues cannot beraised in the short run, that leaves monetary expansion or borrowing.

2.21 One could take a dynamic view of the net impact on monetaryexpansion over time. Service payments are saved over time after debt isretired, the net demand on monetary expansion declines, and eventuallyresults in a "reduction" in the demand for monetary expansion compared tothe case with no swap. Under the assumptions used, the net demand shiftsfrom an increase to a decrease in the fifth year, and the cumulative impacton reserve money is negative in the seventh year. That is, over a sevenyear period, a program of debt equity swaps has a zero net impact onmonetary expansion. This is illustrated in Graph 1 where the annual andcumulative net impacts on reserve money are shown.8 The intertemporalelement of the swap is important, as demonstrated in these figures.9

8/ For a unit swap program of $100 million per year for 5 years, 30Zdiscount captured by the Central Bank and no additionality.

9/ The same analyses and relation would apply if the analysis were basedon base money rather than reserve money.

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Graph 1: PHILLIPINESImpact: Debt Equity Swap on Res. Money

Bllion Pesos10

5 ..................................................................................................................................................

0

5 .................... ............................................ .............. .............. I....................... ..... I....... .......... I. ............. ................................................................\....

_5 ..............................................................................................................I..............I.............. .................... .................................................................\.......... .

-161 ..... .. '

- Net Cumm. Change -Net Change

-20 l l l1989 1991 1993 1995 1997 1999

Year

The effect of a unit swap programof $100 million p.a. for five years

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2.22 Since contracts in the Philippines do not tend to be indexed andthe economy is not hypersensitive to inflation, as is the case in LatinAmerica, cost push factors stemming from other possible policy actions, suchas a modest devaluation or raising the tariffs of public enterprises, shouldnot be additive to the inflation resulting from monetary expansion over theexpected ranges of these variables. In fact, those price increases wouldtend to reduce real demand and the public sector deficit, and thus theywould lower the demand pressure on prices.

2.23 The above analysis assumes that the economy has little excesscapacity and is near full employment. Any increment to demand would thenhave a greater impact on prices than production. To the extent that thereis excess capacity in the economy, then the demand created by the swapprogram will have less impact on prices and more on increasing production.For example, if the investment encouraged by the swap program increaseddemand for construction to enlarge capacity, and if there are unemployedresources in the construction sector, production rather than prices will goup in the first round. Output in the construction sector in 1987 (the mostrecent data available) was 9Z below output in 1983 in nominal terms, andabout one half the 1981-83 average in constant 1972 Pesos, so there shouldbe substantial capacity to be tapped. Since labor is unlikely to be abottleneck, it is likely that the extra investment demand generated by aswap program would have a larger impact on production rather than prices inthe first round.

2.24 The income generated in the construction sector however wouldspill over into the rest of the economy and could drive up other pricesunless there were general excess capacity. This second round inflationarypressure would be attenuated to the extent that the new investment increasedthe resources available to the economy domestically or for export. Thesecond round impact will also be attenuated by lags and leakages, sodirecting the incremental resources into investment activities is likely tohave a lower impact on inflation than general monetary expansion. Moregenerally, any investment in additional, efficient, productive capacity willincrease supply in the economy over time and dampen the inflationarypressure of the expenditure that created the investment.

2.25 The Central Bank has the option of sterilizing the monetarycreation resulting from the debt equity swaps by issuing an amount of bondsequal to the payments to redeem the debt. This offsets the impact of thenew money issued and effectively transfers the cost of prepaying the debt tothe private financial markets in the short run. In the long run, however,the Central Bank will still have to raise the resources to retire thedomestic debt, and in the meantime, the Central Bank will still be paying

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interest to domestic creditors. Whether the domestic interest payments willbe more or less expensive depends on the discount the Central Bank is ableto get when it redeems the debt and the relative levels of domestic andforeign interest rates. As shown in Table 3.1, if the interest rate on therescheduled debt is 102 and the Central Bank redeems the debt at a 30%discount, its interest payments will be less as long as the domesticinterest rate it pays is less than 14.3%, and similarly for other values ofthe discount. However, as long as the Central Bank is paying interest, theinternal rate of return of the swap is lower than if the Central Bank hadpaid off the debt entirely.

TABLE 8.1

EQUJlVALENT DOMESTIC INTEREST RATE

Rate on Discount R-ceivod by Contral Bank /aExternal Debt 6% lOX 15X 20% 26% 30% 35% 40X 46X 60X 66% Sox

8.6X 8.9X 9.4 10.OX 10.6 11.3% 12.1 X13.1% 14.2% 16.X5 17.01 18.9X 21.3X

9.0X 9.5X 10. OX 10.6 11.3X 12.0% 12.9% 13.8% 16.0X 16.4X 18.0X 20.0% 22.5%

9.SX 1O.OX lO.1 X 11.2X 11.9X 12.7% 13.6X 14.6 X15.8X 17.3 X19.0X 21.1X 23.8X

10.OX 10.5X ll.lX 11.8%X12.5X 13.3X 14.3X 15.4 18.7X 18.2X 20.0X 22.2X 26.0X

10.5X ll.lX 11.7X 12.4 13.1 X14.0X 15.0X 16.2X 17.5X 19.1X 21.0X 23.3X 26.3%

ll.OX ll.8X 12.2% 12.9X 13.8X 14.7X 16.7X 18.9X 18.3X 20.0X 22.0X 24.4% 27.6X

/I 5X discount implios that the govornmont receives 5 por 100 of thoconverted debt faco valuo.

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2.26 The extent that the authorities can use this option depends onother demands on the capital markets and the target level of the interestrate. The larger the government deficit that must be financed by issuingtreasury bills and notes, the less scope there will be for additional bondissues to finance swaps for any given interest rate target.

2.27 The Central Bank may also offer to swap foreign debt for long termlocal currency denominated debt to be held or used to repay domestic debtrather than to be turned into investment. This option is primarilyappealing to firms with debts to the the Central Bank, to owners of flightcapital, or to other potential investors who are looking for long termassets (e.g. pension funds). A program of debt for debt swaps with limitedtransferability in the short term might offer some possibilities forretiring debt if the combination of discount and interest rate can be madeattractive enough. For example, if an investor were able to buy Philippinedebt at a 50Z discount and redeem it at 701 of face value for a debtinstrument paying 14Z, that would be equivalent to a nearly 201 return onthe actual investment, which may be attractive.

2.28 The question of issuing long term bonds to be resold in the marketto raise investment funds for current disbursement is more problematic. Ina fully integrated capital market, this is no different than the CentralBank issuing the bonds and paying the investor directly, except there ismore intermediation. It would have the same effect on the market: otherborrowers would be squeezed and interest rates increased. Only if one canshow that the market is segmented by time preference can one argue thatthis might raise otherwise unavailable funds. And it must be furtherargued that private investors would be better able to tap this long termmarket than the Central Bank.

2.29 In determining the size of a swap program, the authorities mustconsider the amount of money creation, debt expansion and reflow ofrescheduled debt to the Central Bank that can be allocated to debt equityswaps, consistent with the expected rate of return on swaps and othermacroeconomic targets, particularly inflation. In the followingquantitative analysis, the effects of a unit program of expenditures of$100 million per year for five years on debt equity swaps are presentedunder different assumptions on other aspects of the program. If theCentral Bank collects a portion of the discount in the debt conversion(through an auction or other mechanism) and retires that amount of money,or equivalently only redeems the debt at a percentage of face value, theamount of debt retired and the benefits will be larger for a givenexpenditure than through redemption at face value.

2.30 The experience elsewhere and the Philippine experience with theprivate debt suggest that the Central Bank should be able to capture 30-40Xof the face value of redeemed debt when the secondary market discount isaround 50Z. It is currently between 50Z and 60% off face value. Dependingon the conversion rules, this could leave the investor with a bonus of up

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to 40-20Z on his invested funds, some of which will accrue tointermediaries. This should be a sufficient bonus for investors. Withthese parameters, a debt reduction program of $100 million equivalent peryear in CB expenditures would retire $143 million in debt per year with 30Zof face value to the government and $167 million per year with 40Z to thegovernment. The net money creation requirement in the first year, aftertaking account of reduced interest payments, would be about Pesos 1.8-1.9billion ($90 - 95 million equivalent), depending on the level ofconversions and discount to the Central Bank.

TABLE 3.2

PHILIPPINES

IMPACT OF 5 YEAR CENTRAL BANK SWAP PROGRAM ON MONETARY EXPANSION

Expenditure on Debt Retirement ($mil/yr) 100 100Percentage share of face value to CB (Z) 30Z 40Z

Debt Retired ($millyr) 143 167Debt Retired after 5 years ($ million) 714 833

Net Monetary Creation Year 1 (P. bil) /a /c 1.9 1.8Net Monetary Creation Year 5 (P. bil) la Ic -0.4 -0.8

IRR (Z) on Reserve Money Creation /b Ic 22Z 27ZNPV at 10Z (P. bil) on Reserve Money Creation /b /c 4.3 6.2

(a Assumes 20 P/$./b Compared to servicing the debt on the current rescheduled maturities./c Results slightly more favorable if some additionality is assumed.

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2.31 The reduction of future service payments that result from debtretirement considerably reduce future expansionary impact of a program asthe Central Bank would not have to create or raise the domestic currency tobuy the foreign exchange to make the service payments. For such a program,the net impact on monetary expansion turns negative in the fifth year.That is, the reduction in demand for resources to service debt is greaterthan the increase in demand for resources for the swap program. So if theinflationary potential of the first couple of years can be absorbed, theexpansionary impact of the swap program will reverse itself and freemonetary expansion capacity of the Central Bank for other needs.10 Inaddition, expenditure leakages into imports of capital goods will reducethe inflationary potential. If the imports of incremental investments arefinanced by using banking sector foreign reserves, then overall domesticdemand could be reduced by Pesos 600 million. The Internal Rate of Return(IRR) on reserve money creation is 22-27% and the net present value of theincreased expenditures (at 10Z) is Pesos 4.3-6.2 billion.

(c) Impact On The Balance Of Payments

2.32 Debt equity swaps give rise to direct foreign investment (DFI)without an actual inflow of additional foreign exchange. Externalliabilities are reduced instead, and any difference between the value ofthe debt reduction and the size of the investment (due to the discount orfee captured by the Central Bank) is accounted as a capital gain on assetvalues. Alternatively, one can assume that the foreign exchange that wouldhave been used to buy Pesos to make the investment is immediately used toprepay foreign debt at a discount. The prepayment saves future foreignexchange payments by the Central Bank and has a high rate of return. But,the economy does not gain access to the foreign exchange that otherwisewould have flowed in with the DFI, which reduces the availability of freeforeign exchange in the short run. The extent to which this intertemporaladvancing of payments can be made depends on the overall tightness of theforeign exchange markets and the additionality of the swap financedinvestment.

2.33 The question of the availability of foreign exchange must beresolved in the country's overall economic planning. The example of $100million per year in expenditure on a swap program would substitute for alike amount of DFI inflows and reduce debt by $143-167 million per year.The net impact of foregone DFI inflows and lower service payments on gross

10/ In this analysis, it has been assumed that the Central Bank issuesmoney to prepay the debt through the swap program, or to purchase theforeign exchange needed to service the debt without the swap program.Obviously other resources (budget transfers) could be used in eithercase, but assuming the government is strapped for resources, theanalysis is going to come to the same point, e.g. increased governmenttransfers will increase the budget deficit and require more CentralBank financing. If the resources were available without increasing thedeficit, then they could be used in the swap and eliminate theinflationary impact.

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revenues ranges from $71 to 93 million in lower reserves in the first yeardue to lower service payments, but the negative impact declines and becomespositive in the fifth year.1 1 (See Table 3.3 and the detailed tables inAnnex I.) The total cumulative impact on the balance of payments becomespositive after the sixth year if there is no additional investment. With30% additionality, this break even period may be shortened by one year.12

This level of foreign exchange use in the first year is less than 3? ofexports and less than one third the annual average improvement in netinternational reserves of the banking system and Central Bank in 1986-87.Nevertheless, since the level of reserves is quite low, this use will haveto be evaluated against alternative demands for reserves. In making suchcomparisons, it should be noted that the internal rate of return on thisuse ranges between 22Z and 33Z. The Net Present Values are between $213and 336 million per $100 million of program.

TABLE 3.3

PHILIPPINES

IMPACT OF 5 YEAR CENTRAL BANK SWAP PROGRAM ON BALANCE OF PAYMENTS

a b c d

Expenditure on Debt Retirement ($mil/yr) 100 100 100 100Percentage Share to Central Bank (Z) 30? 30? 40? 40?Additionality factor (X) o0 30Z 0? 30?

Debt Retired ($mil/yr) 143 143 167 167Debt Retired after 5 years ($mil) 714 714 833 833

B of P Saving ($mil/yr) year 1 7 -2 8 -1B of P Saving ($mil/yr.) year 5 121 103 142 124Net B of P (inc DFI foregone $mil/yr) year 1 -93 -72 -92 -71Net B of P (inc DFI foregone $mil/yr) year 5 21 33 42 54

IRR B of P 22Z 27? 27? 33?NPV at 10? B of P ($mil) 213 237 312 336

Note: Column heading letters refer to sets of tables in Annex I which showgreater detail over the period 1989-2000.

11/ This takes account of dividend remittances on additional investment aswell, which are a burden on the balance of payments but not the CentralBank's domestic resources. Data is limited on the rate of profitremittances in the Philippines some firms reinvest their earningsrather than repatriate them for tax and business reasons. There isstrong evidence that much of the swap investment is return of flightcapital, and that investment would not generate a demand forrepatriation of earnings.

12/ To the extent investment is additional, the foregone DFI is, of course,lower.

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2.34 When there is no additional investment, the reduction of theexternal debt is greater than the prepayment cost to the Central Bank (inproportion to the discount received by the Central Bank) and the futurerepayment liability on the "reduced" foreign claim is transferred to theprivate sector (or eliminated if the swap is made with flight capital).The amount of foreign exchange that would otherwise have flowed in isreduced in favor of a reduction in debt at a discount. When there is someadditionality to total investment, there will be added benefits from thehigher level of investment and growth fostered by the swap program.13 Thelack of free foreign exchange due to the additional investment is not lostforeign exchange, since that DFI would not have occurred without theprogram. There will be additional current demand for imports to realizethe investment and future demands for dividend and capital repatriation,which would put an additional demand on available foreign exchange. Thisdemand can be partly reduced by the design of the program and will bepartly offset by the foreign exchange savings in service payments. Therest of the increased demand for foreign exchange will have to be absorbedthrough using reserves. Available data from the Central Bank indicatesthat 23Z of investment project costs go to imports in the Philippines,experience elsewhere suggests that about 40Z go for imports. To beconservative, 30% of project costs are assumed to be imported.

2.35 Table 3.3 shows the full impact on the balance of payments of afive year, $100 million per year Central Bank swap program with noadditionality and with 301 additionality. It assumes the current repaymentschedule of rescheduled debt and a 10 of assets dividend transfer rate 2years after the investment is undertaken. A 10? interest rate is assumed.Half of interest payments is saved in the year the debt is retired, and allinterest is saved in subsequent years.

2.36 Some countries have tried to mitigate the additional demand forforeign exchange by requiring that the investor to use swapped funds onlyfor local expenditures and that he finance his imports separately.However, since the Philippines capital account is relatively open, the netimpact would be to reduce the amount of debt retired through each projectin the program and the share of the discount obtained by the government.If the investor can only use the swap for a smaller portion of hisinvestment, he will demand a larger share of the discount on that portionto get the same overall bonus. It would probably be better to set thelevel of annual swaps at an amount that can be absorbed, capture as much ofthe discount as possible, and dispense with as many constraints aspossible.

2.37 Table 3.4 compares a straight foreign investment with (a) the caseof a Full Swap with no additionality, where the investor is not required to

13/ It may also be argued that the increased investment brings technologytransfer and other disembodied gains to the Philippines, but thatanalysis is beyond the scope of this paper.

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put up additional foreign exchange for imports, (b) a Domestic Cost Swapwith no additionality, where the investor is required to pay separately forhis imports, (c) a Full Swap that is fully additional, and (d) a DomesticCost Swap that is fully additional. A constant 302 bonus to the investorin each case has been assumed. Other assumptions are as stated in thetable. For simplicity a single currency unit is used for both domestic andforeign currency. This results in no loss in generality.

TABLE 3.4

PFiILIPPINES

COMPARISON OF EFFECTS OF VARIOUS IMPORT REQUIREMENTS

No Additionality Full Additionality(,)7 (b) (C) (d)

No Full Domestic Full DomesticInvestor Impact Swap Swap Cost Swap Swap Cost Swap

(1) Investment Project Cost 100 100 l00 100 100(2) Investment Financed by Swap - 100 70 100 70(3) Debt Retired [(2)/(1-(9))] - 154 98 164 93(4) Investor FX to Rotire Debt ((3)s(1-(a))J - 77 47 77 47(6) Use of Investor FX for Imports ((1)*(c)] 30 - 30 - 30(6) Use of Domestic FX for local costs 70 - - - -(7) Total Inv-stor FX Costs ((4)+(6)+(6)] 100 77 77 77 77(8) Foe to Government t(3) -(2)] - 54 23 54 23(9) As Share of Debt Retired t(8)/(3)] - 3S% 26X 5% 25%

(10) Reserve Money Used to R-tir- Debt (net) ((2)] - 100 70 100 70(11) Reserve Mon-y/100 of Debt Retired [(2)/(3)*100] - 65 75 a6 75

Balance of Payments Impact

(12) Inflow of FX for Investment 100 - - - -(13) Outflows of FX for Imports [(1)*(c)] 30 30 - 30 -(14) Net Change in Reserves [(12)-(13)] 70 -30 - -30 -(15) Net Change Compared to No Swap - -100 -70 -30 -(16) Net Change per 100 of Debt Retired [(16)/(3)*100] - -86 -76 -20 0

Assumptions

(a) Market Discount 30%(b) Investor Conuo 30%(c) Import Content 30%

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2.38 For an investment project of 100, foreign investment without aswap brings in a net of 70 in foreign exchange (100 investment less 30 usedfor imports). A non-additional Full Swap will retire debt worth 154, butuses 30 in reserves to pay for imports. The investor keeps a bonus of 23in local currency equivalent (100-77) and pays fees to the government of 54(154-100). The difference between regular DFI and the swap is a net lowerlevel of reserves of 100, less the reduced stream of debt service payments,which are not included here. In the Domestic Cost Swap, only 93 of debt isretired. Because of the smaller amount of debt retired and the smallerbase for the bonus, the government is only able to collect a fee of 23equivalent (93-70). The net impact on reserves is that they are lower by70, but less debt is retired. It would take additional investment projectsto retire as much debt as in the previous case. Under these assumptions,it takes 65 net use of reserves and emission of reserve money to retire 100of debt in a Full Swap, but 75 with a Domestic Cost Swap. With a DomesticCost Swap program, the amount of fee the government can collect is verylimited for a given level of bonus and market discount. If the marketdiscount fell to 40Z, the government would not be able to collect a fee ifthe 302 bonus, and a lower amount of debt could be retired for a givenlevel of Central Bank expenditure. (See Annexes I for detailed analyticproof.)

2.39 If the investment project is fully additional, the relationbetween the fee and bonus remains the same, as does the use of reservemoney. However, the balance of payments situation improves. With a FullSwap, the net impact on reserves is -30, while for the Domestic Cost Swap,there is no immediate impact on reserves. However, this favorable resultassumes the investor acquires his foreign exchange for imports entirelyfrom sources outside the Philippines. If he is able to use Pesos toacquire them from the foreign exchange holdings of Filipino banks, thencountry loses the favorable balance of payments impact and retires lessdebt than in the Full Swap case. In considering whether to requireinvestors to finance their own imports, the government should consider thata Full Swap program will retire a larger amount of debt per unit ofexpenditure for prepayment and per project than a Domestic Cost Swap, butthat for additional investment projects, the use of reserves will begreater in a Full Swap if the imports are fully financed outside thePhilippines.

(d) Integrating The Debt-Equity Swaps Into The Macro Plan

2.40 The above analysis shows that the benefits from the debt equityconversion program come with short run costs in terms of monetary expansioncarrying inflationary potential, possible upward pressure on interestrates, and reductions in the availability of unrestricted foreign exchange.While these costs are more than offset by the reduction in monetaryexpansion and lower service payments that occur over the following severalyears due to the debt reduction, the short run impacts must be incorporatedinto the country's macroeconomic planning.

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2.41 The government must first establish the priority of debt reductionand investment encouragement in its overall macro targets, based on thebenefits described above. It must then determine how much of its"resources" from monetary expansion, increased resource mobilization,higher interest rates, and/or reduced reserves that it can afford to applyto debt reduction. These resources should be budgeted in the overallmacroeconomic planning; the amount of the swap program firmly establishedin terms of the mechanisms described in the next section; and the programimplemented in a consistent manner. By budgeting the resource in this way,the effects will be already included in the overall projections, and thegovernment will avoid surprises.

2.42 In its decision making, the government must also decide whether toallow Filipinos to participate in the program and whether to requireinvestors to bring in new money. Excluding Filipino investors would reducethe possibility of the Central Bank's or banking system's own reservesbeing used to acquire debt for conversion and increase the likelihood oflimiting the program to non-national sources of foreign exchange. It wouldalso reduce the opportunity to attract flight capital. However, given therelative openness of the capital markets and the ease of setting up dummyoffshore corporations, such a prohibition is unlikely to have much impacton Filipino investors who really want to take advantage of the swapprogram, and those who do through offshore corporations will have rightsfor dividend and capital payments to the overseas entity nominallyundertaking the investment. On the other hand, allowing Filipinoparticipation is more likely to encourage the repatriation of flightcapital, which does not give rise to future capital outflows. This alsoavoids creating incentives to evade the regulations. Careful monitoring offinancing sources should be instituted to limit the ability of investors toborrow locally and acquire foreign exchange on the local market in order tobuy debt for conversion.

2.43 The analysis above shows that requiring the investor to financehis imports with funds from sources outside the swap program will have amore favorable effect on the balance of payments only if the investment isstrictly additional and if the resources are foreign exchange ownedpreviously by the investor or borrowed externally without displacing otherlending to the Philippines (e.g. using up ECA cover limits). Otherwise,that requirement will not improve the balance of payments impact comparedto allowing the imports to be financed with proceeds of the swap. On theother hand, requiring the imports to be financed separately reduces theshare of the market discount the Central Bank can collect for a given bonusto the investor and reduces the amount of total debt the Central Bank canretire for a given expenditure of reserve money. The authorities will haveto take these factors into consideration in designing their program.

(e) The Asset Privatization Program

2.44 It has been argued that using debt to privatize assets implicitlyincreases the government deficit because in the absence of the swapprogram, the government would have received cash. This is a narrow

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viewpoint. First, since the swap retires debt at a substantial discount,the use of the program to reduce debt has a high rate of return andsignificantly reduces future budget expenditures allocated to service thedebt. Second, the government collects a fee for the conversion whichreduces the budget 'loss'.

2.45 Three factors influence the attractiveness of the assets beingprivatized: the final cost to the investor, the investment code benefits hewill receive; and the retained bonus on debt swapped in the transaction, ifany. Under the current rules, the investor does not know if he will beable to use swapped debt in his purchase, so he must bid on the assumptionthat he will not. Any additional bonus from the swap is a windfall to theinvestor, except for the fee charged by the government. By redesigning theprogram to allow the potential investor to include the use of the swap inhis price calculations, the government can increase its gain, either bygetting a higher net price or obtaining a larger fee. In effect, this willreduce the bonus to the investor from the swap and finance a greater partof the cost of the privatization with the discount offered on the debt.

2.46 For example, under the current system, an investor mightsuccessfully purchase a Pesos 1 billion (book value) asset with a bid ofPesos 250 million. If he is then able to acquire his Pesos through a debtswap, he will have to pay $9 million (Pesos 180 million) to acquire Pesos360 million face value of debt (at a 50Z discount) to swap for Pesos 360million with which to pay the 30Z fee (Pesos 110 million) and end up withPesos 250 million to pay for the asset. If the swap rights were includedin the bidding, it is likely that the government could capture some of thePesos 70 million bonus he made on swap. Assume that the government is ableto capture Pesos 40 million of the bonus in a higher fee. The investorwill then have to buy debt for $10 million (Pesos 200 million) and swap thedebt for Pesos 400 million to pay the fee of Pesos 150 million and payPesos 250 million for the asset. The net foregone budget revenue in thefirst year would be Pesos 100 million, (250 foregone revenue less 150 fee)compared to the deal with no swap, or to Pesos 150 million under thecurrent swap program. But the $10 million purchase of discounted debtretires $20 million in obligations, and the government saves interestpayments of Pesos 40 million per year for the next 5 years, and largeramounts in subsequent years when amortization payments would begin. Thenet impact on the government budget turns positive after the third year.If the assets privatized were earning net revenues, the savings on futureservice payments would have to be reduced by the foregone revenues.

2.47 Tables 3.5 shows the impact of a four year program of $100 millionin swaps per year on the budget for a 30Z and 402 fee respectively. Thenet impact on the budget is small if the fee is about 40Z, which wouldstill leave the investor with a bonus of about 202 on his outlay. Aboutone third of the government debt would be retired and almost half of theprivatization program financed. The balance of payments impacts arerelatively small.

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TABLE 3.5

PHILIPPINES

IMPACT OF 4 YEAR APT SWAP ON BUDGET AND BALANCE OF PAYMENTS la

Expenditure or Debt Retirement (P. bil/yr.) 2.0 2.0Percentage Share to Government (Z) 30Z 40Z

Debt Retired ($mil/yr.) 143 167Debt Retired after 4 years ($ mil) 571 667

Payment to budget (P. bil) year 1 1.0 1.5Payment to budget (P. bil) year 5 -2.3 2.7

Net impact on budget (P. bil) year 1 -1.0 -0.5Net impact on budget (P. bil) year 5 2.3 2.7

Net B of P effect ($mil) year 1 -93 -92Net B of P effect ($mil) year 5 114 133

IRR budget 42Z 87ZIRR B of P 22Z 27%NPV at 102 budget (P. bil) 6.4 9.6NPV at 10X B of P ($mil) 185 268

/a If it is assumed that some APT operations are additional because ofthis program, the B of P effect becomes more favorable.

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(f) Aggregate Effects

2.48 Table 3.6 shows the combined impacts of the Central Bank and APTprograms at the levels suggested above. The possible benefits are quiteimpressive. The amount of debt retired over the 5 year period would rangefrom $1.3 to 1.5 billion or up to 10X to 122 of the commercial debtcurrently outstanding. Service payments would be reduced by up to $0.3billion per year. The rate of return on resources used in this way ishigh. The costs to the economy are added pressure on monetary expansion(inflation), on interest rates (if more domestic debt is issued), and onreserves. These are short run impacts, as the resources to repay the debtwould have to be mobilized at some point in any case. Although these costswill be offset by savings on debt service payments, it is important toexercise care that they do not disrupt the government's efforts to maintainprice stability and appropriate real interest rates. If the swap programcan be managed within the limits of prudent macroeconomic policy, it islikely that the program will stimulate additional investment and attractsubstantial amounts of flight capital back to the Philippines. Thesebenefits will depend on the credibility and continuity of the program andon some modifications in its design suggested below.

TABLE 3.0

PHILIPPINES

AGGREGATE IMPACTS OF CENTRAL BANK AND APT SWAP PROGRAMS

a b c d

Expenditure on Debt Rotirement (Smil/yr) /a 200 200 200 200Percentage Share to Central Bank and govornment (N) 30X 30% 401 40XAdditionality factor (X) (Central Bank only) OX 301 OX 30%

Debt Retired (Smil/yr) /n 286 286 333 333Debt Retired after 6 yoars (Smil) 1,286 1,286 1,600 1,600

Not B of P (inc DFI foregone tmil/yr) yoer 1 -186 -135 -183 -132Net B of P (inc DFI forogone Smil/yr) year 5 136 139 175 178

IRR B of P 221 29% 271 36XNPV at 10X 8 of P (Smil) 398 489 S80 651

Net Budget/Monetary Impact (P. bil/yr) year 1 /b 2.9 2.8 2.3 2.3Net Budget/Monetary Impact (P. bil/yr) year 6 -2.7 -2.8 -3.5 -3.6

IRR Budgot/Monetary Impact 29X 29X 42X 43XNPV Budget/Monetary Impact (P. bil) 10.7 10.9 16.8 16.0

NB. Column hoeding refer to sets of table. in Annox I showing groat-r detail.

/a For first 4 years, fifth year is less as the APT program in not functioning in that year./ (C) = inflationary impact.

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III. THE MECHANICS OF DEBT EQUITY CONVERSIONS

3.01 The concept behind debt-equity conversions is relativelysimple, but the mechanics of designing and implementing a workingprogram are complex. This complexity arises because governments oftentry to achieve several objectives through these transactions. At best,these objectives overlap; at worst, they conflict. For example, onetrade-off in designing a program pits the goal of administrative easeagainst the objective of preventing round-tripping. A further area ofpotential conflict is the problem balancing the participation of localinvestors with the necessity to control the impact on the balance ofpayments. The result is that there is no "perfect" design for aconversion program. Each element requires compromises between competinggoals, a trade-off which every government must decide for itself. Thepolicy makers first should decide on their relative priorities among theobjectives of debt reduction, investment encouragement, repatriation offlight capital, and priority sector development. Once these prioritiesare clear, a debt-equity swap program can be designed to conform tothose relative priorities.

Measures to Increase Additionality

3.02 In order to increase additionality in any program, the bestcourse would be to maintain a steady program of sufficient duration tooutlast the necessary incubation period of potential projectpreparation. A program that switches on and off would not achieve this.In order for potential investors to undertake feasibility studies, theyneed to know that a government has a long-term commitment to permittingdebt-equity transactions. Consequently, if a debtor government decidesto establish or resume a program, it should consider announcing aminimum of a five-year program. Although the government could suspendthis commitment before the period expires in case of an emergency, theinitial commitments would be a valuable signal in the meantime forstimulating interest among possibly additional investors.

3.03 Another significant factor affecting additionality is the sizeof the bonus that investors receive. If the incentive is too small,then it will not prove sufficient to attract the interest of uncommittedinvestors. It is, of course, difficult to determine how large a bonusis enough. There is, for instance, the interest among Philippineinvestors to acquire and convert private-debt paper, even when thisproduced a bonus of under 1O, but this may not be additional. However,given the large demand for swaps, the government should not allow toolarge a bonus, or the implicit subsidy to non-additional investors willbe hard to justify and the distortions in investment incentives will betoo great. Since Philippine debt now is selling at discounts of 50-60Z,the Central Bank should be able to capture a substantial portion of thediscount and still leave a handsome bonus for the investor. This wouldhelp increase the amount of debt retired.

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3.04 Several factors affect the size of the bonus actually receivedby the investor: the share of the discount claimed by the governmentfor converting the debt to local currency, issuing a bond for the debtthat has to be negotiated at less than face value, taxing the capitalgain created by the conversion, or requiring "fresh money" in additionto the conversion. As analyzed above some, such as requiring "freshmoney," reduce the efficiency of the swap program in reducing debt andoffer few benefits. It is best to keep the conversion process as simpleas possible.

3.05 If an auction is used, limiting too tightly the total amount ofconversions may push the resulting bonus below the level needed tostimulate additional investment. This is because non-additionalinvestors could bid down the amount of the bonus to a low level. Toavoid this problem, the market created by an auction should be deepenough to prevent non-additional investors from "squeezing out'additional ones. The size of each auction needs to be set with thissituation in mind.

3.06 Additionality may be increased by reserving certain benefitsfor 'regular' investments made without a debt-equity conversion. Theidea is to strike a balance between the advantages available to normalinvestment and the bonus produced by a conversion. If this balance isachieved, then non-additional investors (i.e. those investors who do notneed a conversion bonus) will be no worse-off if they elect to make aregular investment. In practice, striking a perfect balance will behard because of the large advantage of a conversion. If the governmentconsiders that the incentives created by a conversion bonus plus thenormal investment incentives, which conversion projects are currentlyentitled to are too large, the government could consider removing someof the normal incentives for investments made through conversions. InArgentina, a successful bidding under the country's conversion programrequires the removal of tax benefits that could be available underdifferent federal programs. This Argentinean policy does not appear tohave deterred additional investments made through conversions.

3.07 Under Circular 1111, priority projects encountered no obstacleon dividend payments; they could remit earnings from the first yearonward. Moreover, they could begin to remit investment principalbeginning at 20Z in the fourth year. These aspects may be tightenedwithout weakening the appeal of the conversion program for additionalinvestors. Such restrictions are generally imposed under conversionprograms in operation in Chile, Brazil and Argentina. In fact,interviews with over one hundred investors revealed that significant(although not excessive) restrictions on the timing of both dividend andcapital transfers were not perceived to pose an obstacle for additionalinvestment.1

11 Debt-Equity Swaps, op cit, p.25

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Such restrictions are found to have been responsible for convincing somenon-additional investors to pursue a regular investment instead ofapplying for a conversion. It would therefore be advisable for thePhilippines to consider the creation of a waiting period for dividendsand to lengthen the existing time frame for repatriating principal.2

Approval Process and Auction System

3.08 The demand by investors for debt-equity conversions normallyexceeds the limitations set by a government on the size of the program.Conversion rights are thus a scarce commodity, which a government needsto allocate. Different allocation methods are available, and the choicethat a government makes among the alternatives depends on its prioritiesand will shape the overall nature of its program.

3.09 Conversions may be allocated by government fiat. Under thismethod, a government receives a pool of applications and then evaluateseach project against a set of general criteria. These criteria reflecta government's judgment on the types of investments that are desirable.The goal is to identify the applications that meet these criteria and toreserve the conversion bonus exclusively for them. This case-by-casemethod enables the host government to exert a greater degree ofinfluence over the direction of the investment. For example, in thisapproach, the government can encourage investment in certain sectors,ensure a higher level of technology transfer in appropriate cases, andinsist that certain investments have a higher export orientation.Essentially, this is the system of Chile for debt/equity conversionsunder Chapter 19 and that which operated under Circular 1111 in thePhilippines.

3.10 On the other hand, however, there are potentially both economicand administrative problems with allocating conversions by governmentdecision. There is no guarantee that the approved projects will beeconomically efficient. The government may try to judge, ex ante,whether a project will be economically viable, but the government'sability to foresee the vagaries of the marketplace may be limited.Consequently, this system of allocating conversions may provide bonusesto unsound projects, while denying assistance to efficient investments.Furthermore, there is no guarantee that a system of government decision-making will be able to set fees that capture the largest availableportion of the secondary-market discount.

3.11 Administratively, government decision-making creates a heavyworkload for the bureaucracy, which must examine the details of everyapplication. Often, a complete evaluation requires inputs from severalgovernment agencies, whose separate analyses must be coordinated.

2/ Such convertability limitations may require consultation with theIMF.

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Moreover, this process is time consuming, which forces investors to waitfor a reply. Under the procedures of Circular 1111, investors often hadto wait for up to two months before receiving a decision whether theycould use the debt equity swap program, assuming that they had submittedfully complete applications. Finally, this method lacks transparency.No matter how professionally the government evaluates applications, theprocess still occurs behind closed doors, giving rejected anddisgruntled investors the grounds for complaining about a lack offairness.

3.12 An alternative method for allocating conversions is to create acompetitive market through an auction. Applicants may bid against eachother for access to a fixed amount of conversions. This method willautomatically screen projects for economic efficiency, because the mostprofitable projects should be able to bid the highest. Also, it willdeliver the largest possible portion of the secondary-market discount tothe government. Additionally, this market-driven approach would be farsimpler to administer than by government approval. It would requireless manpower, produce results quicker, and be fully transparent.

3.13 To assure that certain government concerns about investmentallocation under the market method of approval are met, a "negativelist" may be prepared, specifying sectors that are off-limits to debt-equity conversions. The forbidden sectors would include any area of theeconomy from which private investment is normally excluded. Also, thelist would set aside sectors where the present level of investment isalready adequate, or where the government believes that a bonus is notneeded. This would provide an a priori basis to exclude sectors inwhich the financial returns are already high enough to encourageinvestment. For example, given the broad level of trade protection inthe Philippine economy, the government may wish to exclude some highlyprotected import substitution subsectors from the conversion program.

3.14 Brazil and Argentina have chosen market based auctionprocedures to allocate access to conversions. Since early 1988, therehave been ten auctions in Brazil and eight in Argentina. Neither Brazilnor Argentina exclude domestically-oriented investments from theconversion process. From the experiences of these auctions, thefollowing several observations can be made.

3.15 First, using auctions need not necessarily preclude screeningof conversion projects by the government, although the screening processin this case tends to be lighter than under the negotiation approach.For example, in Argentina the Ministry of Economy screens eligible

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projects which may be presented to Central Bank auctions. This processmay not be onerous but strict enough to screen out conversionapplications for patently non-productive investments. Second,establishing different auctions for investment of different priorityseems to work. In Brazil, there are two different auctions: one for"incentive" projects in some less developed, priority regions in thenortheast and the other for "non-incentive" projects anywhere else inthe country. The first auction has channeled almost as much investmentfunds as the second, although the auction discounts in the first wereconsiderably lower than in the second. In Argentina there is a separatefunctioning auction which is limited to the prepayment of Central Bankmedium-term rediscount facilities, in addition to the one for regularinvestments.

3.16 Third, commitments by the government to the market system andits efficient administration are crucial to the success of auctions. Inboth countries, the government establishes in advance conversionceilings for each auction. In Argentina, for example, based on macro-economic considerations, the government has established auction amountsof $50 million in conversion value for every bi-monthly auction on afive-year basis. Presentation to the auction must be made through alocal bank (Agent Bank) authorized by the Central Bank to operateforeign exchange. Acceptance of bids is decided strictly on the basisof the auction discount (Central Bank fee portion) offered for theconversion. In Brazil, the auctions start with an initial discount of0.5Z. The minimum amount to be offered is $100,000, and only multiplesof the minimum amount can be offered. If the total amount offered bythe participants is greater than the ceiling of the Central Bank, thediscount will increase by 0.5Z. This process will continue until thetotal offer is equal or lower than the ceiling.

3.17 Fourth, results under these auctions generally support the viewthat this method captures a larger share of the discount for the CentralBank than under the negotiation method. As Table 4.1 shows, althoughthey are subject to variation, the auction discounts (central bank feeportion) as well as the government's share of the secondary marketdiscounts have been on the rise as the market price of debt declinedover the last several months. The average government share in thedifference between face value and secondary market price was 69Z inBrazil and 77Z in Argentina, which were higher than in Chile (less than30%) where the negotiated method was used.

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TABLE 4.1: Auction Discounts, Market Prices, Government'sShare and Incentives to Investors

(Z)

Country Av. Auction Market Govt.'s Share/i Incentive to/2and Date Discount Price of Market Discount Investors

(of face value) (of face value)

Argentina /3

Jan 20, 88 36.7 32.0 54.0 97.8Mar 29, 88 53.9 27.0 73.8 70.9Jun 10, 88 57.7 27.0 79.0 56.8Sep 22, 88 66.1 24.0 87.0 41.1Dec 15, 88 71.9 21.5 91.6 30.7Mar 28, 89 72.0 18.0 88.0 56.0

Average 59.7 78.9 58.9

Brazil 14

Mar 88 27.0 46.0 50.0 58.7Apr 88 32.0 50.0 64.0 36.0May 88 22.0 54.0 44.9 44.0Jun 88 13.5 52.0 28.7 66.3Jul 88 24.0 52.0 58.7 40.4Aug 88 29.5 47.0 55.7 50.0Sep 88 34.5 47.0 65.1 39.4Oct 88 38.0 47.0 71.7 31.9Nov 88 50.0 42.0 86.2 19.0Dec 88 59.0 39.5 81.0 29.1

Average 32.3 68.6 41.5

Chile

Average 11.0 /5 59.0 26.8 50.8

Source: Prepared from the information in Debt Auction and Conversion Data,Latin Finance, January 1989 and a report of Banco Rio del la Plata S.A.

IL Estimated using the formula: average auction discount/ (1 - marketprice of debt)

/2 Estimated using the formula: [(1 - average auction discount)/marketprice of debt)] - 1

This ignores commissions, taxes and other expenses for arrangingconversion transactions. Thus, actual incentive to the investor wouldbe smaller than the figures indicated here.

/3 Auctions for regular investments.14 Free area auctions.(5 Central Bank fees.

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3.18 Finally, these auctions appear to have been effective inachieving conversion objectives. As the conversion volume increased andthe level of auction discounts rose, substantial amounts of foreign debtwere retired. About $2 billion in Brazil and about $1.3 billion inArgentina, in face value of debt were retired during 1988 through theauctions. In Argentina where local participation is allowed, more localinvestors than foreign ones have participated in the auctions,repatriating flight capital to the country. Conversions have financed avariety of investment projects with total costs of approximately $700million. Specific design of an auction in the Philippines, if it wereso decided, would have to be the object of further discussion betweenthe government and its financial advisors. The detailed design would bea function of the government's objectives, and the rules and customs offinancial transactions in the Philippines.

Preventing Round-Tripping

3.19 Debt/equity conversions create arbitrage opportunities (round-tripping), which, if left unchecked, could lead to serious abuses of theconversion program. For example, in debt equity swaps, investors thatwould otherwise retain earnings in the country are encouraged to takefunds out and bring them back through swaps, taking advantage of thepreferential exchange rate. Careful design and implementation of theconversion program can help reduce round-tripping. It may be minimizedat the outset by checking the credentials of investors, but verifyingtheir reliability in advance of the actual conversion is far fromfoolproof. Also, as in Chile, the differential between official andparallel exchange rates can be closely monitored by the authorities tocontrol volumes of conversions and incentives for round-tripping. Thesemeasures will reduce the potential for round-tripping in general.

3.20 In specific projects, further monitoring can limit this danger.In the past, the Central Bank has guarded against round-tripping bycontrolling the disbursement of converted funds. Investors have had topresent invoices and other valid receipts to the Central Bank beforefunds could be paid directly to the suppliers of goods and services.This arrangement cast the Central Bank into the role of paymaster forthe conversion program. Its staff had to check the accuracy of everydemand for payment and determine its legitimacy. Needless to say, thisimposed an administrative burden, which represented a "hidden cost" ofmaintaining a conversion program.

3.21 By using an alternative method for disbursing funds, theCentral Bank may be able to lighten its administrative burden withoutsacrificing the adequacy of controls against round-tripping. Followinga system which was effectively utilized in Mexico, direct responsibilityfor paying-out funds could be transferred to Philippine commercial

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banks, which would be required to apply the same rigorous verificationprocedures now followed by the Central Bank. It should not be difficultfor the commercial banks to handle the disbursement of fundsefficiently; many of them have already adopted similar safeguards forthe release of loans for projects they finance. In order to meet thecosts of verifying invoices and providing other services, commercialbanks could be permitted to charge investors a small fee. To the extentthat the same commercial banks also operate as the investors' agents inconversions, they can include the disbursement fee in their overallcharges.

3.22 Under this modified system, the focus of the Central Bank's jobwould shift away from checking each invoice toward overseeing theoperations of the commercial banks. The Central Bank would want to keeptabs on the overall process, as well as occasionally to "spot check"specific projects. If the Central Bank uncovers an irregularity indisbursements, then it could penalize the commercial bank. The idea isto transfer responsibility for applying the correct procedures onto theshoulders of the banking community. An effective penalty for abuse maybe to prevent banks which disburse funds incorrectly from acting asagents in the conversion program, thereby denying them an opportunity toearn lucrative fees.

3.23 By "privatizing" the disbursement process, both the CentralBank and the commercial banks will be able to operate in the ways theyknow best. The Central Bank has more experience monitoring theactivities of the commercial banking system than in supervisinginvestment projects. Commercial banks, however, have daily experiencehandling project expenditures. Under the proposed system, the CentralBank would be able to operate within its own area of expertise bymonitoring the commercial banks to ensure that disbursements areproperly made. At the same time, commercial banks would functionaccording to their strengths at the project level.

3.24 Finally, an effective monitoring program during the post-investment phase can help to reduce round-tripping. The Central Bankshould consider expanding and standardizing its current reportingprocedures, which should be required of all projects financed by aconversion. Reporting on the use of conversion proceeds should occur ona frequent basis (maybe quarterly), in order to uncover discrepanciesbefore it becomes too late to correct them. From time to time, theCentral Bank will have to verify the accuracy of reports with on-siteinspections. A system of reasonable penalties needs to be developed andclearly stated in a revised circular. A special "penalty tax" may needto be levied against projects found to be in violation of conversionprocedures.

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IV. CONCLUSION

4.01 Debt equity swaps require current cash resources to retire thedebt presented by the potential investors. It follows that the amount ofdebt that can be retired through such conversions will be limited by thedebtor country's ability or willingness to commit the resources required toeffect what amounts to a buy-back of debt. Depending on how the currentresources are generated, there can be inflationary or interest ratepressure. A sustained and predictable program can, however, have asignificant impact over time in reducing the stock of debt.1

4.02 Debt-equity conversion programs provide an investment incentive,in the form of an up front bonus equivalent to the difference between thesecondary market price of debt and the redemption price in local currencyactually received. Such up front investment incentives would be ofparticular interest to investors because they both reduce total expenditureon the investment and raise the financial rate of return.

4.03 Debt equity swaps are attractive to creditor banks because theyincrease demand for debt in the secondary market and make it easier forbanks wishing to sell their debt to do so at more favorable prices. Eventhe banks who choose to hold their debt benefit from the higher marketvalue of the debt and the greater likelihood the remaining debt will beserviced as total debt is reduced. Thus, the issue of establishing orresuming a conversion program will probably be an element in thenegotiations with creditor commercial banks on debt restructuring and newmoney facilities.

4.04 The potential for debt equity conversions to induce inflationdepends on the type of debt being converted. Conversions of debt owed byprivate borrowers, the national government, or public sector enterprisesfinanced by their own resources is not likely to lead to an increase inaggregate demand unless overall credit to the economy is allowed to expandto finance these conversion transactions. However, when the Central Bankretires its debt by issuing cash to be used for investment, there is apotential inflationary impact. The analysis indicates that, in the case ofthe Philippine program using a realistic range of assumptions, for each$100 million equivalent of expenditures, $145 to $170 million in debt wouldbe retired, requiring about pesos 1.8 billion ($90 million equivalent) innet expenditures in the first year. However, the net impact on expansionof reserve money will decline over time and will turn negative in the fifthyear as the reduction in expenditures to service debt is greater than theexpenditures for the swap program.

1/ Chile has retired over $5 billion of its debt since 1985 through itsdebt conversion programs including debt-to-debt conversions underChapter 18. Brazil retired over $8 billion of debt during 1988 throughdebt conversions. About $2 billion of debt were retired under theconversion program and about $6 billion through informal conversions.

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4.05 Debt equity swaps give rise to direct foreign investment withoutan actual inflow of additional foreign exchange, which reduces theavailability of free foreign exchange in the short run. For each unit of$100 million per year for five years of debt reduction payments, theanalysis shows the net impact of foregone DFI inflows and lower servicepayments will range from $71 to 93 million in lower reserves in the firstyear, but the negative impact declines and becomes positive in the fifthyear. The total cumulative impact on the balance of payments would becomepositive after the sixth year if there is no additionality. If there issome additionality to total investment, the initial adverse effects woulddecline more quickly.

4.06 The mechanisms for implementing a program can have a great effecton the program's efficiency in meeting the government's objectives. Aconsideration to be weighed is the size of a bonus to give the investor; alarger bonus may encourage more additional investment, but will reduce thebenefit to the government and the amount of debt reduction for aconstrained volume of conversion resources. The best way to increaseadditionality would be to maintain a steady program of sufficient durationto outlast the necessary "incubation" period of project preparation andinvestor confidence. A program that switches on and off would not achievethis. In order for potential investors to undertake feasibility studiesand do adequate project preparations, they need to know that the governmenthas a long-term commitment to permitting debt-equity transactions.

4.07 When the government's resources for swaps are limited, conversionsmay be allocated by a government fiat. Under this method, a governmentreceives a pool of applications and then evaluates each project against aset of general criteria. This is the system of Chile under Chapter 19 andthat operated in the Philippines under Circular 1111. An alternativemethod for allocating conversions is to create a competitive market throughan auction. Under this system, applicants may bid against each other foraccess to a fixed amount conversions. This would help deliver the largestpossible portion of the secondary market discount to the government. Sucha market-driven approach would be simpler to administer than governmentevaluation of individual projects.

4.08 There could be, however, certain trade-offs. Because the investoris unable to determine his actual capital costs until after the auction,auctions may introduce some uncertainty into the investment decision-makingprocess. Generally, this uncertainty is viewed as a disincentive,particularly in the case of large new projects. Moreover, the case-by-casemethod enables the host country to exert a greater degree of influence overthe direction of the investment. For example, in this approach, thegovernment can encourage investment in certain sectors, ensure a higherlevel of technology transfer in appropriate cases, and insist that certaininvestments have a higher export orientation. However, the case by case,negotiated method is costly in terms of government manpower, delays, andthe lack of transparency, regardless of how scrupulous the negotiations.

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4.09 From the experiences of recent auctions in Brazil and Argentina,several observations can be made which may be useful for a debtorgovernment to consider in designing its program. Using auctions does notnecessarily preclude screening of conversion projects by the government.The government can screen out projects which may be considered non-desirable. Different auctions for investment of different priority can beestablished. In Brazil, the separate auction for "incentive projects" inless developed, priority regions in the northeast has channeled as muchinvestment funds as the other auction for 'non-incentive projects' anywhereelse in the country. Commitments by the government to the market systemand its efficient administration are important for the success of auctions.The government's share was considerably higher under the auction systemthan under the negotiated method.

4.10 A debt equity conversion program can generally contribute toachieving several government objectives. However, depending on itsstructure, there can be conflicts among those objectives in that achievingone may affect achieving others. For example, if a debtor governmentwishes to achieve primarily debt reduction, its conversion program would bestructured with a screening procedure that passes projects up to the limitof resources available. This would encourage a large volume of conversionsfor investment, additional or not, and provide a large share of secondarymarket discounts to the government. On the other hand, if the primaryobjective were to promote additional investment, and/or investment inpriority sectors, it is important to keep the level of incentive higher andinclude criteria to screen out investments that are not additional. If aprogram were oriented strongly to additionality, it would run the risk thatthe conversion volume would remain small, that bonus and supervision costswould be high, and that it would have much less impact on debt reduction.

4.11 On the basis of an analysis of potential benefits as well as costsof conversions, and an assessment of the capacity of the economy to absorbthe short-term macroeconomic impacts, decisions have to be made by thedebtor government as to whether and to what extent it wants to allow theconversion of its debt paper. Also, a decision has to be made as to whatshould be the primary objective it wishes to achieve through conversions:debt reduction or investment additionality. Should the government decideto establish a program, it would need to formulate long-range operationaltargets by types of conversion and integrate their likely impacts into theoverall macroeconomic planning. This would allow the required resources tobe budgeted and the program implemented in a consistent manner.

ANNEX 1

ANALYSIS AND PROJECTIONS OF MACRO-ECONOMIC IMPACTS

(A) Projections of Economic Impacts

(B) Demonstration of Relation Among Variables

- 35 -

- 36 -

AMMX TABLE I aPHILIPPtNES: INPACT OF SWAPS ON ULANCE OF PAYMENTSDfI* S100 APT* S100 GovSh a 30% Add OS lipShu 30X

(USS eillionr at Current Prices)1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

(1) Debt Retirement 143 143 143 143 143 0 0 0 0 0 0 0(2) DFI tl1) 1 - (b)) 100 100 100 100 100 0 0 0 0 0 0 0(3) Inftlow foregon (2) (1 - (f))] 100 100 100 100 100 0 0 0 0 0 0 °(4) Capitel pin (1) - (2)] 43 43 43 43 43 0 0 0 0 0 0 0

CS) Interest Savings t(17) * Cc)] 7 21 36 S0 64 71 71 71 71 71 71 71(6)'Arortization Saving (17) ̂ 1/(d)] 57 71 71 71 71 71 71 71(7) Dividend Repetriatfon C(1S(t 2))(g)(f)1 0 0 0 0 0 0 0 0 0 0 0 0(8) Incrme_ntal Iportst(2) (f) (h)] 0 0 0 0 0 0 0 0 0 0 0 0

(9) met loP Savfng C(5) + (6) - (7) - (8)] 7 21 36 50 121 143 143 143 143 143 143 143

(10) Net BoP effect (IMF) C(3) - (9)] (93) (79) (64) (50) 21 143 143 143 143 143 143 143

(milLion Pesos at Current Market Prices)(11) Honey creation ((2) * (e) / 1000] 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(12) Interest Saving C(5) * (0) / 10001 0.1 0.4 0.7 1.0 1.3 1.4 1.4 1.4 1.4 1.4 1.4 1.4(13) Amortization Saving (6) C M e) / 1000] 0.0 0.0 0.0 0.0 1.1 1.4 1.4 1.4 1.4 1.4 1.4 1.4(14) Leakae fro Inc lmportstE.3(8)*(e)/1000 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(15) Net Cheng Roe Mony(11)-012)-013)-(14)1 1.9 1.6 1.3 1.0 (0.4) (2.9) (2.9) (2.9) (2.9) (2.9) (2.9) (2.9)(16) Cmuul. Net Chonoe Ree Monry (lit P) 1.9 3.4 4.7 5.7 5.3 2.4 (0.4) (3.3) (6.1) (9.0) (11.9) (14.7)

(USS mitlions at Current Prices)(17) Cumul. Net Debt Retired 143 286 429 571 714 714 714 714 714 714 714 714

Cunul. Interest Saving 7 29 64 114 179 250 321 393 464 536 607 679Cunut. Amortization Saving 0 0 0 0 57 129 200 271 343 414 486 557CLuel. Reduction inCA 0 0 0 0 0 0 0 0 0 0 0 0Cuut. Capitfel Reptriatirn 0 0 0 0 0 0 0 0 0 0 0 0Cuiul. Net loP Sving 7 29 64 114 236 379 521 664 807 950 1,093 1,236Cueut. SoP Effect (93) (171) (236) (286) (264) (121) 21 164 307 450 593 736

(18) Cimul. DFI 100 200 300 400 500 500 500 500 500 500 500 500

(a) Market Discount 50X (e) Exchnge Rate P/S 20 IRR of Net Res Money 22%(b) Share of Gov 30X (f) Additional Investment 0O NPV 910% Net Res Mon(P bil) 4.3(c) Interest Rate 10t (g) Dividend rate 10% IRR of Net BoP 22%(d) Amort. Period, Yrs 10 (h) Irport Share 30X NPV a 10X Net BoP (S mil) 213

.

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AMNEX TALE ItI PHILIPPINS; IPACT OF SUWS ClN tE UGDETDi S100 APT a S100 loGO a 30X Add* OX IMpSM 30X

(UI .it1i1n1 at Currant Prices)1969 1990 1991 2 1993 1994 1995 1996 1997 1998 1999 2000,... .. . ..... .... .... . .... .... . .... .... . .... .... . ... .. .... .. .........

(1) Asset Set" a eenu eLoss) 100 100 100 100 0 0 0 0 0 0 0 0(2) Debt retired (1)1(1 (bf] 143 143 143 143 0 0 0 0 0 0 0 0(3) Cost to Invstor C(2) (1 (-))] 71 71 71 71 0 0 0 0 0 0 0 0

(4) Fee pid Governmnt E2) * b)I 43 43 43 43 0 0 0 0 O O O(5) Interest Saving E(10) * (c)] 7 21 36 50 ST 57 57 57 57 57 57 57(6) Amortfiatfan Saving [(10) * (d8) 57 57 57 57 57 57 57 57(7) Total lefit to Governmmnt 1C4).(5).6)I 50 64 79 93 114 114 114 114 114 114 t14 114

(8) Not ludgt Saving ttO - (0)1 (50) (36) (21) (7) 114 114 114 114 114 114 114 114(9) Culoative Not Saving (50) (86) (107) (114) 0 114 229 343 457 571 686 800

(10) Cwultative Debt Retired 143 286 429 571 571 571 571 571 571 571 571 571(11) Cumietive Asset Sates 100 200 300 400 400 400 400 400 400 400 400 400

(ittlion Pesos at Current Market Prices)(12) Asset Price (Revee Loss) C(1?)Ct)/1000I 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

(13) fe Pefd to Government t(4) * (W) / 10001 0.9 0.9 0.9 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(14) Interest Saving [(5) * (o) / 10001 0.1 0.4 0.7 1.0 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1(15) Amortizotion Saving [(6) * C.) / 10002 0.0 0.0 0.0 0.0 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1(16) Total Bsnfit to Govern. (12)*(13)0(14)3 1.0 1.3 1.6 1.9 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3

(17) Net udpt Saving t(16) (12)1 (1.0) (0.7) (0.4) (0.1) 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3(18) Cumutative met Saving (1.0) (10.7) (2.1) (2.3) 0.0 2.3 4.6 6.9 9.1 11.4 13.7 16.0

BALANCE OF PAYIIENTS IMPACT(USS mittioen at Current Prices)

18) Debt Retir_nt 143 143 143 143 0 0 0 0 0 0 0 0(19) DFI t(18) * (1 - (b))3 100 100 100 100 0 0 0 0 0 0 0 0(20) Inftow for t(09) (1 - (f))3 100 100 100 100 0 0 0 0 0 0 0 0(21) Capitel gain t(18) - (19)3 43 43 43 43 0 0 0 0 0 0 0 0

(22) Interest Savings 10) * (0c) 7 21 36 50 57 57 57 57 57 57 57 57(23) Amrtization Saving [(10) * 1/(d)l 57 5' 57 57 57 57 57 5(24) DividWd Reptrlation[0(11){t-2)g)*(ft) 0 0 0 0 0 0 0 0 0 0 0 0

(25) Not oP Saving t(22) + (23) (24)1 7 21 36 50 114 114 114 114 114 114 114 114

(26) Net BoP effect (IMF) E(20) (25)1 (93) (79) (64) (50) 114 114 114 114 114 114 114 114

(a) Market Dfsca, 50X (a) Exchange late (P/S) 20 IRR of lpact on Budget 42%(b) Govermnt She 30X (f) Additionality 0O NPV 9105 of lpact on Budget(P bit) 6.4Ce) Interest Nate 10t (g) Dividend rate 10X IRR of Net Ilpact, BoP 22%(d) Aort Pnrlod, 10 (h) loeort Share 30X NPV 10X of Met I"pact, SoP (Smit) 185

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ANEX TABLE III aPNILIPPINES: OVERALL IMPACT OF SWP PROGMDFI a $100 APT a $100 GovSh * 30X Add * 0% OXpSh 30%Central Bank Conversion Payments 100 Mitlion per yeor, Five yearsGovern_nt Conversion Pay tsnts S100 Nillion per year, Four years

(USS millions at Current Prices)1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

*alunce of Payments Iqwct .... --- --- .... -- - -- - -- - .... .......... ......... ... ... . ..

TotaL lnflow Foregon 200 200 200 200 100 0 0 0 0 0 0 0Total Debt Retired 286 286 286 286 143 0 0 0 0 0 0 0

Total Interest Saving 14 43 71 100 121 129 129 129 129 129 129 129Total Amortization Saving 0 0 0 0 114 129 129 129 129 129 129 129Total Dlvidend Pyments t-) 0 0 0 0 0 0 0 0 0 0 0 0Totat Incr_ntaolIports -)0 0 0 0 0 0 0 0 0 0 0 0Total Not oP Saving 14 43 71 100 236 257 257 257 257 257 257 257

Net Baansce of Paymnts Ict (186) (157) (129) (100) 136 257 257 257 257 257 257 257

CuLulativt BoP Savings 14 57 129 229 464 721 979 1,236 1,493 1,750 2,007 2,264Cm.leative *saenc of Paymnts Ict (186) (343) (471) (571) (436) (179) 79 336 593 850 1,107 1,364Cumulative Debt Retired 286 571 857 1,143 1,286 1,286 1,286 1,286 1,286 1,286 1,286 1,286

Budget lect (Billion Pesos at Current Market Prices).............

Forgone reveJ 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Monetary ExpanIon 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Expenditure Ict 4.0 4.0 4.0 4.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Fee 0.9 0.9 0.9 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Interest Saving 0.3 0.9 1.4 2.0 2.4 2.6 2.6 2.6 2.6 2.6 2.6 2.6Amortization Saving 0.0 0.0 0.0 0.0 2.3 2.6 2.6 2.6 2.6 2.6 2.6 2.6Lokkge 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Budget inflow/Saving 1.1 1.7 2.3 2.9 4.7 5.1 5.1 5.1 5.1 5.1 5.1 5.1

Not Expnionary Isect 2.9 2.3 1.7 1.1 (2.7) (5.1) (5.1) (5.1) (5.1) (5.1) (5.1) (5.1)

Cimlative Net Impact 2.9 5.1 6.9 8.0 5.3 0.1 (5.0) (10.1) (15.3) (20.4) (25.6) (30.7)

(a) Market Discoun 50% (e) Exchang Rate (P/S) 20 IRR of Budget lpqct 29%(b) Goverrmnt Sha 30% (f) Additionlity 0% NPV 910% of Bud Iect(P bil 10.7(c) Interest Rate 10% (9) Dividend ratc 10% IRR of BoP lct 22%td) Amort Period, 10 (h) Inport Share 30X NPV 910% of BoP IectCS mil 398

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ANNEX TABLE I bPHILIPPINES: IMPACT OF SWAPS ON ALANCE OF PAYMENTSDFI* S100 APT a $100 GovSh a 30X Add* 30 lwpSh. 30X

(USS millions at Current Prices)1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

(1) Debt Retir_ment 143 143 143 143 143 0 0 0 0 0 0 0(2) DFI [(1) * (1 -(b))] 100 .. 100 100 100 100 0 0 0 0 0 0 0(3) InfLow foregonel(2) * - (f)) 70 70 70 70 70 0 0 0 0 0 0 0(4) Capitat gain (C) - (2) 43 43 43 43 43 0 0 0 0 0 0 0

(5) Intcrest Savings 1(17) * (c)) 7 21 36 50 64 71 71 71 71 71 71 71(6) Amortization Saving E17) * 1/(d)] 57 71 71 71 71 71 71 71(7) Dividend Reptriation l(t-2))(g)'(f)3 0 0 3 6 9 12 15 15 15 15 15 15(8) increm_ntat Imports E(2) (f) (h)] 9 9 9 9 9 0 0 0 0 0 0 0

(9) Net *oP Saving E(S) + (6) - (7) - (8)] (2) 12 24 35 103 131 128 128 128 128 128 128

(10) Not SoP effect (INF) ((3) - (9)3 (72) (58) (46) (35) 33 131 128 128 128 128 128 128

(Bitlion Pesos at Current Market Prices)(11) Morey creation ((2) * () / 10003 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(12) Interest Saving ((5) * (e) / 10003 0.1 0.4 0.7 1.0 1.3 1.4 1.4 1.4 1.4 1.4 1.4 1.4(13) Amortization Ssving t(6) * (e) / 10003 0.0 0.0 0.0 0.0 1.1 1.4 1.4 1.4 1.4 1.4 1.4 1.4(14) Lookag from Inc lports[.3*(8)-(e)/10003 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0(15) Net Change Rce Non*y[(11)-(12)-(13)-(14)I 1.8 1.5 1.2 0.9 (0.5) (2.9) (2.9) (2.9) (2.9) (2.9) (2.9) (2.9)(16) Cumul. Not Change Ree Money (Bit P) 1.8 3.3 4.6 5.5 5.0 2.2 (0.7) (3.6) (6.4) (9.3) (12.1) (15.0)

(USS miltions at Currant Prices)(17) Cunul. Net Oebt Retired 143 286 429 571 714 714 714 714 714 714 714 714

Cuul. Interest Saving 7 29 64 114 179 250 321 393 44 536 607 679Cmeul. Amortization Saving 0 0 0 0 57 129 200 271 343 414 486 557CLun. Roduction in CA 9 18 27 36 45 45 45 45 45 45 45 45Cuult. Capital Repatriation 0 0 3 9 18 30 45 60 75 90 105 120Cumul. Net BoP Saving (2) 11 34 69 173 304 431 559 687 815 943 1,071Cumul. BoP Effect (72) (129) (176) (211) (177) (46) 81 209 337 465 593 721

(18) Cumul. OFI 100 200 300 400 500 500 500 500 500 500 500 500

(a) Market Discount 50X Ce) Exchang Rate P/S 20 IRR of Net Res Money 23%(b) Share of Cov 301 (f) Additional Invstment 30X NPV B101 Net Res Mon(P bil) 4.5(c) Interest Rate 10X (9) Dividwed rate 10X IRR of Met BoP 27X(d) Amort. Period, Yrs 10 (h) Import Share 30X NPV a 10X Net SoP (S mit) 237

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ANNEX TABLE II bPhILIPPINES; INPACT OF SWAPS ON TNE UDCiEDFI * S100 APT* Sa100 ov4h 304 Add 30% Iqpihu 30%

CUSS filtans at Current Prfces)1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

. . . . . . . . . .. . .. . .. ... .... ... ... ... ... ... ... ... .. . .. . . ... .... . -. -- . . . ..

t1) Asst Se C(Rsvnwu Lose) 100 100 100 100 0 0 0 0 0 0 0 0(2) Debt retired [(I) / (1 (b)N3 143 143 143 143 0 0 0 0 0 0 0 0(3) Cost to investor C(2) (1 - (a))3 71 71 71 71 0 0 0 0 0 0 0 0

(4) Fe peid Goverra nt 2) * (b)] 43 43 43 43 0 0 0 0 0 0 0 0(5) Interest Saving [(I0) * Cc)] 7 21 36 50 57 57 57 57 57 57 57 57(6) Amortization Saving (10) * (d)) 57 57 57 57 57 57 57 57(7) Total tenfit to Goverrawnt so4).C5).(6)1 50 64 79 93 114 114 114 114 11 114 114 114

(C) Net Budget Saving [() - (1)3 (50) (36) (21) (7) 114 114 114 114 114 114 114 114(9) Cuulative Net Saving (50) (86) (107) (114) 0 114 229 343 457 571 686 800

(10) Cuulative Debt Retired 143 206 429 571 571 571 571 571 571 571 571 571(11) Cmulative Asset Sales 100 200 300 400 400 400 400 400 400 400 400 400

(Billion Pesos at Current Market Prices)(12) Aset Price (Revenue Loss) (0)(e/10001 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

(13) Fee Paid to Government ((4) * (e) / 1000I 0.9 0.9 0.9 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(14) Interest Saving [(5) * (e) / 1000W 0.1 0.4 0.7 1.0 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1(15) Amortization Saving 1(6) * (e) / 10001 0.0 0.0 0.0 0.0 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1(16) Total Bnefit to Govern. C(12).C13)0(14)I 1.0 1.3 1.6 1.9 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3

(17) Net Budget Saving 1(16) - 12)] (1.0) (0.7) (0.4) (0.1) 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3(18) Cumulative Met Saving (1.0) (1.7) (2.1) (2.3) 0.0 2.3 4.6 6.9 9.1 11.4 13.7 16.0

BALANCE OF PAYMENTS IMPACT(USS milLions at Current Prices)

(18) Debt Retire_ nt 143 143 143 143 0 0 0 0 0 0 0 0(19)DFI [ 8) * (1 - (b))] 100 100 100 100 0 0 0 0 0 0 0 0(20) Inflow foregon tC09)*(1 -tf))] 70 70 70 70 0 0 0 0 0 0 0 0(21) Capital gain [(18) - (19)] 43 43 43 43 0 0 0 0 0 0 0 0

(22) Interest Savings E(1O) * (0)] 7 21 36 50 57 57 57 57 57 57 57 57(23) Amortization Saving ((10) * 1/Cd)l 57 57 57 57 57 57 57 57(24) Dividend Repetriationt(11)(t-2))*(g)*(f)I 0 0 3 6 9 12 12 12 12 12 12 12

(25) Met SoP Saving (t22) + (23) - (24) 7 21 33 44 105 102 102 102 102 102 102 102

(26) Net BoP effect (IMF) E(20) - (25)] (63) (49) (37) (26) 105 102 102 102 102 102 102 102

(a) Market Discoun 50% (e) Exchang Rate (P/S) 20 IRR of Impact on Budget 42%(b) Goverin nt She 30% (f) Additionality 30% NPV G10% of tapact on Sudget(P bit) 6.4(c) Interest late 10% (g) Dividend rete 10% IRR of Net lpect, BoP 31%td) AODrt Period, 10 (h) lIport Share 30% NPV 0 10% of Net lpact, BoP (Smil) 232

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ANNEX TABLE III bPHILIPPINES: OVERALL IMPACT OF SWAP PROGRAMDFI a S100 APT* S100 GovSh* 30X Add* 30X lopSh- 30XCentral Bank Conversion Payuants S100 Million per year, Five yearsGovernoont Conversion Pyments $100 Milifon per year, Four yeors

(USS millions at Current Prices)1989 1990 1991 1992 1993 1994 199 199 1997 1998 1999 2000

Balance of Payments Impact .... .... --- --- .... -- - - .... ----

Total Inflou Foregon 140 140 140 140 70 0 0 0 0 0 0 0Total Debt Rttired 286 286 286 286 143 0 0 0 0 0 0 0

Total Interest Saving 14 43 71 100 121 129 129 129 129 129 129 129TotaL Amortization Saving 0 0 0 0 114 129 129 129 129 129 129 129Total Dividend Poymnts (-) 0 0 6 12 18 24 27 27 27 27 27 27Total Incrementali Iportsct) 9 9 9 9 9 0 0 0 0 0 0 0Totol NIt BoP Saving 5 34 56 79 209 233 230 230 230 230 230 230

Net Balwce of Pamnts Impact (135) (106) (84) (61) 139 233 230 230 230 230 230 230

Cu muative oP Savings 5 39 96 175 383 616 847 1,077 1,307 1,537 1,767 1,997Cumulative Bwalnce of Payments Impact (135) (241) (324) (385) (247) (14) 217 447 677 907 1,137 1,367Cumulative Debt Retired 286 571 857 1,143 1,286 1,286 1,286 1,286 1,286 1,286 1,286 1,286

Budget Impact (Billion Pesos at Current Market Prices).............

Foregone revw.a 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Monetary Expasion 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Expenditure Impact 4.0 4.0 4.0 4.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Fes 0.9 0.9 0.9 0.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Interest Saving 0.3 0.9 1.4 2.0 2.4 2.6 2.6 2.6 2.6 2.6 2.6 2.6Amortfiztion Saving 0.0 0.0 0.0 0.0 2.3 2.6 2.6 2.6 2.6 2.6 2.6 2.6Leakage 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Budget Inflow/Saving 1.2 1.8 2.3 2.9 4.8 5.1 5.1 5.1 5.1 5.1 5.1 5.1

Net Expanionary Imqct 2.8 2.2 1.7 1.1 (2.8) (5.1) (5.1) (5.1) (5.1) (5.1) (5.1) (5.1)

Cumulative Net Impact 2.8 5.0 6.7 7.8 5.0 (0.1) (5.3) (10.4) (15.6) (20.7) (25.8) (31.0)

(a) Market Discoun 50X Ce) Exchange Rate (P/S) 20 IRR of Budget lpact 30%(b) Govrrment She 30% tf) Additionality 30% NPV 0101 of Bud ImpecttP bil 10.9Cc) Intorest Rate 10X (g) Dividenw rate 10% IRR of BoP lmct 29X(d) Anort Period, 10 (h) Import Share 30X NPV 8101 of SoP Impct(S mil 469

- 42 -

Alhl11 TABLE I CPNILIPPINES: IMPACT OF SAP ON LALMCE OF PAYNENTSOFDP $100 APT a *100 ovh* 41X Add 0IrpSh- 30X

(USt mfItiona at Curront Prices)1969 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

(1) Doebt Rltfr _ nt 167 167 167 167 167 0 0 0 0 0 0 O(2) DFI E(1) (1 - (b))3 100 100 100 100 100 0 0 0 0 0 0 0(3) Inflow foregontl(2) 1 - (f))] 100 100 100 100 100 0 0 0 0 0 O 0(4) Capitao gain t() -(2)1 67 67 67 67 67 0 0 0 0 0 0 0

(5) Inter.t S virgs (1T) * (cfl 8 25 42 58 75 83 83 83 83 83 83 83(6) Amortization Saving 1(T7) * I/Cd)) 67 83 83 83 83 83 83 83(7) Dividend Repatriation t(0&Ct-2))(g)*'f)2 0 0 0 0 0 0 0 0 0 0 0 O(8) Incremental ltorts l) (f) 'h) 0 0 0 0 0 0 0 0 0 0 0 0

(9) Net oP Saving C(5) * (6) (7) (] a 25 42 58 142 167 167 167 167 167 167 167

10) Not oP effect (iNM (3) - (9)2 (92) (75) (58) (42) 42 167 167 167 167 167 167 167

(Sililon Pese at Current Market Prices)(11) oney creation 1(2) * (*) / 10001 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(12) Intereet Saving (C5) * (e) / 10001 0.2 0.5 0.8 1.2 1.5 1.7 1.7 1.7 1.7 1.7 1.7 1.7(13) Amortization Saving ((6) * (e) / 10002 0.0 0.0 0.0 0.0 1.3 1.7 1.7 1.7 1.7 1.7 1.7 1.7(14) Leakage fro Inc Importse.3*(8)*(*)/10002 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(15) Not Change Rs* onry((11)-(12)-(13)-(14)I 1.8 1.5 1.2 0.8 (0.8) (3.3) (3.3) (3.3) (3.3) (3.3) (3.3) (3.3)(16) Cueu. Net Chon tee nony (DiI P) 1.8 3.3 4.5 5.3 4.5 1.2 (2.2) (5.5) (8.8) (12.2) (15.5) (18.8)

(USS killions at Current Price.)(17) CuxuL. Met Debt Retired 167 333 500 667 833 833 833 833 833 833 833 833

Cuvu. Interest Saving 8 33 75 133 208 292 375 458 542 625 708 792Cu u . Amortization Saving 0 0 0 0 67 150 233 317 400 483 567 650Cuoul. Reduction in CA 0 0 0 10 0 0 0 0 0 0 0 0CMaul. Capital Reptrietion 0 0 0 0 0 0 0 0 0 0 0 0Cumul. Not oP Saving 8 33 75 133 275 442 606 775 942 1,108 1,275 1,442Cumul P Effect (92) (167) (225) (267) (225) (58) 106 275 442 608 775 942

(18) Cuutl. DI 100 200 300 400 500 500 500 500 500 500 500 500

(a) Market Discount 50X (W) Exchange Rate P/S 20 IRR of Net Roe Money 27%(b) Share of Gov 40X (f) Additional Investment 0 NPV MO1 Net Res Mon(P bil) 6.2Cc) Intereet Rate 10M (9) Dividwnd rate 10X IRR of Net SoP 27%Cd) aort. Period, Yrn 10 (h) Itort Share 30X wPV a 101 Net soP (S mil) 312

- 43 -

ANNEX TABLE 11 cPHILIPPINES; IMPACT OF SiAPS ON THE IWGETDFI Slo APT a S100 GovSh a 40X Add* 0X ImpSh- 30X

(USS f(Itiona at Current Prices)1969 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000..... ..... .... .... ..... .... ..... .... ---- --- .. *-. .... .. .. ... .

(1) Aasat S&Lee (Roeu Loes) 100 100 100 100 0 0 0 0 0 0 0 0(2) Debt retired ((1) / (1 - (b))3 167 167 167 167 0 0 0 0 0 0 0 0(3) Cost to Investor C(2) * (1- (a))8 83 83 83 83 0 0 0 0 0 0 0 0

(4) Fee pid Goverrwcnt E(2) * Mb 67 67 67 67 0 0 0 0 0 0 0 0(5) Interest Saving (1) * (") 8 25 42 58 67 67 67 67 67 67 67 67(6) Amortization Saving [(10) * (d)) 67 67 67 67 67 67 67 67(7) Total Benefit to Government E(4)+(5)+(6)) 75 92 108 125 133 133 133 133 133 133 133 133

(8) Net Uu et Saving C(() 1)] (25) (8) 8 25 133 133 133 133 133 133 133 133(9) CuJuICtive Net Saving (25) (33) (25) 0 133 267 400 533 667 800 933 1,067

(10) Cumulative Debt letired 167 333 500 667 667 667 667 667 667 667 667 667(11) Cumulative Asset SaLes 100 200 300 400 400 400 400 400 400 400 400 400

(Billion Pesos at Current Market Prices)(12) Asset Price (Revene Loss) E(1)*(*)/10001 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

(13) Foe Paid to Governmnt [(4) * (e) / 10001 1.3 1.3 1.3 1.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(14) Interest Saving t(S) * (s) / 10001 0.2 0.5 0.8 1.2 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3(15) Amortization Saving E(6) * (e) / 10003 0.0 0.0 0.0 0.0 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3(16) Totol Benefit to Govern. tCl2)+*13)+(14)I 1.5 1.8 2.2 2.5 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7

(17) Net Budget Saving [(16) - (12)3 (0.5) (0.2) 0.2 0.5 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7(18) C.w lative Not Saving (0.5) (0.7) (0.51 0.0 2.7 5.3 8.0 10.7 13.3 16.0 18.7 21.3

BALANCE OF PAYMENTS IMPACT(USS miltions at Current Prices)

(18) Debt Retirement 167 167 167 167 0 0 0 0 0 0 0 0(19) DFI C(18)(1 -Cb)) 100 100 100 100 0 0 0 0 0 0 0 0(20) Inflou foregone (19) *1 - (t))] 100 100 100 100 0 0 0 0 0 0 0 0(21) Capital gain ((I8) - (19)3 67 67 67 67 0 0 0 0 0 0 0 0

(22) Interest Savings W(10) * (c)] 8 25 42 58 67 67 67 67 67 67 67 67(23) Amortization Saving E(10) * 1/(d)] 67 67 67 67 67 67 67 67(24) Dividend Rsep tationC(11)(t-2))-(g)*(f) 0 0 0 0 0 0 0 0 0 0 0

(25) Net SP Saving [(22) + (23) (24)] 8 25 42 58 133 133 133 133 133 133 133 133

(26) Not oP effect (IMF) E(20) (25)3 (92) (75) (58) (42) 133 133 133 133 133 133 133 133

(a) Market Discoun 50X (e) Exchang Rate (PIS) 20 IRR of Iwpact on Budget 87X(b) Gover-w_nt Sho 40X (f) Additionatity 0X NPV 01O5 of Impact on Budget(P bil) 9.6(c) Interest Rate 10X (g) Dividend rate 10X IRR of Met lpect SOP 27%(d) Aort Period, 10 (h) import Shoar 30X MPV 9 10X of Net Inpwct, SP (SmiL) 268

- 44 -

ANNEX TABLE III CPNILIPPINES: OVERALL INPACT OF SWMP PROCMADFI * $100 APT * S100 GovSh * 40X Add * 0 N FOpi. 302Central Bank Converslon Payments $100 Miltion per year. Five yearsGovernmnt Conversion Paymnts $100 Million per year. Four years

(US$ milliors at Current Prices)1969 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 20ao

BEalnce of Payx nts Iwpwtt --- -- - - - -- - -- .... -- - ...............................

Total Inflow Foregon 200 200 200 200 100 0 0 0 0 0 0 0Total Debt Ratired 333 333 333 333 167 0 0 0 0 0 0 0

Total Interest Saving 17 50 63 117 142 150 150 150 150 150 150 150Total Amortization Saving 0 0 0 0 133 150 150 150 150 150 150 150Total Dividwn Psy mnts (-) 0 a 0 0 0 0 0 0 0 0 0 0Total IncremmntallIwports ( 0 0 0 0 0 0 0 0 0 0 0 0Total Net W Saving 17 50 83 117 275 300 300 300 300 300 300 300

Net Balance of Paymnts Impact (183) (150) (117) (83) 175 300 300 300 300 300 300 300

Cuirultive woP Savings 17 67 150 267 542 842 1,142 1,442 1,742 2,042 2,342 2,642Ciumlotive Balance of Paym nts Iapct (183) (333) (450) (533) (358) (58) 242 542 842 1,142 1,442 1,742Cuiulative Debt Retired 333 667 1,000 1,333 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500

Budget Impct (Cilfion Pesos at Current Market Prices).0 .0 .0 .0 . . . . . . . .

Foregon revenue 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0onetary Expaw ion 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Total Expenditure Impact 4.0 4.0 4.0 4.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Fes 1.3 1.3 1.3 1.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Interest Saving 0.3 1.0 1.7 2.3 2.8 3.0 3.0 3.0 3.0 3.0 3.0 3.0Amortization Saving 0.0 0.0 0.0 0.0 2.7 3.0 3.0 3.0 3.0 3.0 3.0 3.0Leakegs 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Budget Inflow/Saving 1.7 2.3 3.0 3.7 5.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0

Not Expansionary Ixpct 2.3 1.7 1.0 0.3 (3.5) (6.0) (6.0) (6.0) (6.0) (6.0) (6.0) (6.0)

Cuu.lative Net I pct 2.3 4.0 5.0 5.3 1.8 (4.2) (10.2) (16.2) (22.2) (28.2) (34.2) (40.2)

(a) Market Oiscoun 502 (*) Exchenge Rate (P/S) 20 IRR of Budget Impact 42%(b) Gover-uant Shr 40X (t) Additionality 02 NPV B102 of Bud Impact(P bil 15.8(e) Interest Rote 10X (g) Dividend rate 10X IRR of loP lpact 27%(d) Amort Period, 10 (h) lNport Share 30X NPV 8102 of EoP lpact(S mil 580

.

- 45 -

ANhhX TABLE I dPNILIPPINESt IMPACT OF lIMPS ON UALACE Or PAYMENTSDOI * 100 APT a S100 GovSh a 40% Add* 30S iqh- 30

(USS millions at Current Prices)1909 1990 1991 1992 1993 1994 1995 1996 1997 1996 1999 2000......... ..... ..... .. ....... .... ..... .... ..... .... ..... .... ..... .... ..... ....

C1) Debt Retirment 167 167 167 167 167 0 0 0 0 0 0 O(2) DFI t(1) * (1 - (b))] 100 100 100 100 100 0 0 0 0 0 0 O(3) Inflto for-gme l2) (I1 -(f))] 100 100 100 100 100 0 0 0 0 0 0 O4) Capital gain t1) - 2) 67 67 67 67 67 0 0 0 0 0 O o

(5) Interest Savinp E?7) * (c) 8 25 42 58 75 83 83 83 83 83 83 83(6) Aowtization SavIng ((17) * 1/Vd)] 67 83 83 83 83 83 83 83(7) Dividwn Repetriation E(1(t-D2)*(g)*(f)I 0 0 0 0 0 0 0 0 0 0 0 o(8) Incr _ anto lports (2) *fC) * 0 0 0 0 0 0 0 0 0 0 0 0

(9) Net oP Saving 1(5) E (6) - (7) - (8)] 8 25 42 58 142 167 167 167 167 167 167 167

(10) Net oP effect (IMF) ((3) (9)] (92) (75) (58) (42) 42 167 167 167 167 167 167 167

(lillian Pesos at Current Narket Prices)11) Haney creation E(2) * Ce) / 10001 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(12) Interest Saving E(5) * (C) / 10003 0.2 0.5 0.8 1.2 1.5 1.7 1.7 1.7 1.7 1.7 1.7 1.7(13) Amortization Saving E(6) * Ce) / 10001 0.0 0.0 0.0 0.0 1.3 1.7 1.7 1.7 1.7 1.7 1.7 1.7(14) Leakage from Inc IupeotE.3*(8)*(e)I0003 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(15) Net Chenge Rfe Nnwyl(11)-(12)-(13)-C14)I 1.8 1.5 1.2 0.8 (0.8) (3.3) (3.3) (3.3) (3.3) (3.3) (3.3) (3.3)(16) Cumul. Net Chnge lee Noney (lit P) 1.8 3.3 4.5 5.3 4.5 1.2 (2.2) (5.5) (8.8) (12.2) (15.5) (18.8)

CUSS miltions at Current Prices)(17) Cuol. Not Debt Retired 167 333 500. 667 833 833 833 833 833 833 833 833

Crual. Intereet Saving 8 33 75 133 208 m 375 458 542 625 708 792Cuoul. Amortfiation Savfng 0 0 0 0 67 1S0 233 317 400 483 567 650Cueul. Reduction in CA 0 0 0 0 0 0 0 0 0 0 0 0Cunul. Capitol Poptriaticn 0 0 0 0 0 0 0 0 0 0 0 0Cauul. Net W Saving 8 33 75 133 275 442 608 775 942 1,108 1,275 1,442Canl. eP Effect (92) (167) (225) (267) (225) (58) 108 275 442 608 m 942

(18) Cuiul. DFI 100 200 300 400 500 500 500 500 500 500 500 500

(a) Market Discount 50X (e) Exchang Rot* P/S 20 IRR of Not Nos Money 27X(b) Share of Gov 40X (f) Additional Investment 0O NPV 9102 Net Res Non(P bil) 6.2Cc) interest Rate 10 (9) Dividend rate 10X IRR of Not e0 27XCd) AFort. Period, Yrs 10 (h) leport Share 30X NPV a 102 Net BaP CS mit) 312

- 46 -

ANNEX TABLE 11 dPHILIPPINES; IWPACT OF SWAPS ON TNE UDOETDFI t $100 APT a $100 G&vSh a 40S Add * 0O IupShu 30X

(USS oitlior at Current Prices)1909 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000... ... ... ... ... .... .... . .. ..-.. ... ... ....

(1) Aaset Sete (RevwJn Loss) 100 100 100 100 0 0 0 0 0 0 0 0(2) Debt retired ((1) /C1 - (b))] 167 167 167 167 0 0 0 0 0 0 a 0(3) Cost to Investor E(2) (I -() 83 83 83 83 0 0 0 0 0 0 0 0

(4) Fee paid Goverr_mnt E(2) * (b)] 67 67 67 67 0 0 0 0 0 0 0 0(5) Interest Saving ll10) * lc)] 8 25 42 58 67 67 67 67 67 67 67 67(6) Amortization Saving ((10) * (d)M 67 67 67 67 67 67 67 67(7) Total Benefit to Goverr_wnt E(4)+(5)+(6)] 75 92 108 125 133 133 133 133 133 133 133 133

(8) Net Budget Saving (7) E - 3) (25) (8) a 25 133 133 133 133 133 133 133 133(9) Cmialtive Not Saving (25) (33) (25) 0 133 267 400 533 667 o00 933 1,067

(10) Cuulativf Debt Retired 167 333 500 667 667 667 667 667 667 667 667 667(11) CumJULative Asset Sales 100 200 300 400 400 400 400 400 400 400 400 400

(Billion Pesos at Current Market Prices)(12) Asast Price (Revenue Loss) (1)-(e)/1000] 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.O

(13) Fee Paid to Goverrunnt 1(4) * (e) / 10001 1.3 1.3 1.3 1.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0(14) Interest Saving ((5) * Ce) / 10001 0.2 0.5 0.8 1.2 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3(15) Amortization Saving ((6) * (e) / 10001 0.0 0.0 0.0 0.0 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3(16) Total Benefit to Govern. 0(12)+(13)+(14)3 1.5 1.8 2.2 2.5 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7

(17) Net Budget Saving (106) - (12)3 (0.5) (0.2) 0.2 0.5 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7(18) Cumulative Net Saving (0.5) (0.7) (0.5) 0.0 2.7 5.3 8.0 10.7 13.3 16.0 18.7 21.3

BALANCE OF PAYMENTS IMPACT(US$ milLions at Current Prices)

(18) Debt Retirement 167 167 167 167 0 0 0 0 0 0 0 0(19) DFI 18) * 1 -(b))] 100 100 100 100 0 0 0 0 0 0 0 0

(20) Inflou foregone 9) * 1 1(1 (f))C 100 100 100 100 0 0 0 0 0 0 0 0(21) Capital gaIn ((18) - (19)] 67 67 67 67 0 0 0 0 0 0 0 0

(22) Interest Savings ((10) * (c)] a 25 42 58 67 67 67 67 67 67 67 67(23) Amortization Saving (10) * 1ZCd)l 67 67 67 67 67 67 67 67(24) Dividend Repetri&taon(EC1)(t-2>)*(g)*(f)1 0 0 0 0 0 0 0 0 0 0 0 0

(25) Nht cP Saving E(22) + (23) - (24)] 8 25 42 58 133 133 133 133 133 133 133 133

(26) Net SoP effect (IMF) ((20) - (25)] (92) (75) (58) (42) 133 133 133 133 133 133 133 133

(a) Market 0iscoun 50X (e) Exchange Rate (P/S) 20 IRR of Impact on Budget 87%(b) Government Sha 40$ (f) Additionality O NPV 0102 of Impact on audget(P bit) 9.6(c) Interent Rate 10$ (g) DivIdend rate 10 IRR of Net Impact, oP 27%(d) Amort Period, 10 (h) tmport Shere 30X NPV a 10 of Net Impct. SoP (Smil) 268

C

- 47 -

ANNEX TABLE III dPhILIPPINES: OVERALL IMPACT OF SWAP PROGRAMDfI a $100 APT a $100 GovSh * 40% Add * 0% iOpSb= 30%Central BSnk Conversion Payomnts $100 MilLion per year, Five yearsGovernomnt Corversion Payments $100 Million per year, Four years

(USS miliions at Current Prices)1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

8a1 neo of Pym nto Impact .... .... .... .... .... .... .... .... .... .... .... .............................. ........................... /

Totel lnflow Forgogne 200 200 200 200 100 0 0 0 0 0 0 0Total Debt Retired 333 333 333 333 167 0 0 0 0 0 0 0

Total Interest Saving 17 50 83 117 142 150 150 150 150 150 150 150Total Aortization Sving 0 0 0 0 133 150 150 150 150 150 150 150Total Oividmnd Paymnts t-) 0 0 0 0 0 0 0 0 0 0 0 0Totel Incram_ntat Iports ( 0 0 0 0 0 0 0 0 0 0 0 0Totolt Nt W Sving 17 50 83 117 275 300 300 300 300 300 300 300

Net Salent e of Payents I pct (183) (150) (117) (83) 175 300 300 300 300 300 300 300

Cuiumativ oP Savfngs 17 67 150 267 542 842 1,142 1,442 1,742 2,042 2,342 2,642Cumulative Balane of Paymnts Ipact (183) (333) (450) (533) (358) (58) 242 542 842 1,142 1,442 1,742C =Lative Debt Retired 333 667 1,000 1.333 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500

Budget lopet (Billion Pesos at Current Market Prices).............

Forgon rovwenu 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Monetery Expwn.ion 2.0 2.0 2.0 2.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Expenditure lWpet 4.0 4.0 4.0 4.0 2.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Fo s 1.3 1.3 1.3 1.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Interest Sawing 0.3 1.0 1.7 2.3 2.8 3.0 3.0 3.0 3.0 3.0 3.0 3.0Amortization Saving 0.0 0.0 0.0 0.0 2.7 3.0 3.0 3.0 3.0 3.0 3.0 3.0Lekage 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total Budget Inflow/Saving 1.7 2.3 3.0 3.7 5.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0

Not Expenaionary lIpect 2.3 1.7 1.0 0.3 (3.5) (6.0) (6.0) (6.0) (6.0) (6.0) (6.0) (6.0)

CuLulative Net InD t 2.3 4.0 5.0 5.3 1.8 (4.2) (10.2) (16.2) (22.2) (28.2) (34.2) (40.2)

(a) Market Diacoun 50% Ce) Exchange Rate tP/S) 20 IRR of Budget Impect 42%(b) Goverrmnt She 40% Cf) Additiontlity 0% NPV 910% of Bud lapact(P bit 15.8(c) Interest Rate 10% (g) Oividwnd rate 10% IRR of BaP Impact 27%(d) Aoort Period, 10 (h) Import Share 30% MPV 210% of BoP Ilpect(S mit 580

- 48 -Annex 1 (B)

PROOF

(1) b P F- [m P +D (1-d)]m P + D (1 - d)

(2) D- (P - mP)g D

(3) g - 1 = -P (1 - m)D

(4) D =P (1- m)

(5) ( (1 - m) (1 - d)b - (mP + 1- g P)

(1- m) (1- d) P [(4) into (1)]mP + 1- g

(6) 1 - m (1- m) (1 -d)

1- gb= ---- i:ii ? -:-T

1g

(7)

b 1 -m +mg - 1 + d + m -mdm - mg + 1 - d - m + md

(8) b -+n-nb=d -g + mg -md-

1 - d + mnd - m

(9)b = (d -g) (1 _m)

1 -d+ nm (d - g)

(10)b = bmg + bmd -bd = -g + mg + d - md [from (8)]

(11) -bmg + g - mg= d md - b -bmd + db

(12) g (1 - m - bm) = d -md - b- bmd + db

(13) b(d (1 - m) -1] + (1 - m)

g 1 -- m 1 + -b)

dg_ > 0: d > : dg >0

P = Project CostD = Debt Retired, Face Valueb = Bonus to Investorm = Import Share of Project, Paid Directly by Investord = Discount Off Face Value of Debtmp = Foreign Exchange Payment by Investor for Imports

D (1 - d) = Foreign Exchange Payment by Investor for Local Costsg = Share of Face Value of Debt Retired Paid to Government in Order

to do Swap.(P - mP) = Local Cost of Project Financed by Swap

0< b, m, d, g < 1

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[Also available in Spanish (75S)]

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HO

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