Debt-equity swaps and the enforcement of sovereign loan contracts

This paper analyses the incentive compatibility effects associated with restructuring sovereign debt through a debt-equity swap scheme and the analytically related issue of providing new project finance in developing countries through equity convertible bond issues. Our central result is that these initiatives can generate efficient investment incentives and also provide a partial contractual enforcement mechanism by reconciling the investment interests of debtors and their external creditors. Unlike previous analysis of the benefits of swaps, our results make no appeal to risk considerations nor invoke informational asymmetries. We also derive a necessary condition for swaps to overcome the free-rider barrier to the provision of voluntary, market-based debt relief. In contrast to Brady Plan restructurings, this condition does not rely on taxation of the capital gains accruing to non-participating creditors. The results should be viewed in the context of the structural transformation which has recently occurred in the source of capital flows to developing countries, from syndicated bank lending to the international bond markets. The analysis advocates an enhanced role for equity convertible bond issues in this resurgence of international capital market activity. © 1997 John Wiley & Sons, Ltd.