IFC: Growth and Diversification
In a conversation with Finance & Development Sir William Ryrie, Executive Vice President, International Finance Corporation, covered a broad range of issues facing the IFC. His views on selected topics are presented below
Favorable global environment
The past decade has been a propitious time for IFC, with greater emphasis worldwide on the private sector. There has been a ferment of innovation in financial markets; new techniques have been introduced, as have new ways of dealing with debt problems through market-based solutions. Moreover, there has been growing interest in equity investments in developing countries.
IFC has been a part of these changes, in two main ways. First, by expanding the scale of its activities. Although IFC is still much smaller than the World Bank, the scale on which it now operates is considerable. We approved more than $1 billion of new investments in fiscal year 1988. And, because of our catalytic role (we are always the minority partner financially in any investment we support), the total volume of investments we supported in 1988 was about $5 billion. This general growth of operations is based, of course, on a capital increase approved in December 1985 which is still being paid in.
The second way we have taken advantage of the favorable global policy environment is by diversifying our activities so that we are no longer solely a project finance institution. We are now more an investment bank for development in that we provide a variety of services to the private sector in developing countries. For example, we have been involved increasingly in company restructuring efforts, especially in Mexico and some other heavily indebted countries. This involves helping companies whose basic business is sound but who have severe financial problems that need to be resolved with external technical and financial help. We are also involved in helping privatization efforts by providing advisory services both to governments and to corporations. IFC is now providing more finance through intermediaries so as to reach smaller businesses that we cannot deal with economically ourselves. We are increasingly active in the field of technology transfer and in capital markets activity—helping countries to develop their capital markets, and building links between capital markets in developing countries and the major capital markets—through portfolio funds, debt-equity conversion funds, and underwriting of corporate issues. We have a pretty wide and growing range of activities to meet the needs of our member countries.
Impact of IFC activities
There is a tendency, in some quarters, to measure IFC by how many dollars it invests. The volume of investments is in some ways an indication of our impact but there is a more important role for IFC: as a catalyst in the development process and in helping the private sector in LDCs. IFC’s role is to facilitate the working of markets so that they serve the process of development in our member countries. The diversification of our services is an example of that process. One may not be able to measure the impact of our different activities solely by the volume of dollars invested. One crude measure would be the number of sound companies in the developing world that owe their success in some degree to IFC assistance. We have never made this calculation, but the number is in the thousands.
Profitability versus development
IFC has always been profitable. There is no problem in reconciling the need for profitability with the developmental role of IFC. Of course, it goes without saying that making a profit is not our main purpose. That purpose is development. But because of our special role to promote development through the private sector we have to be interested in profit. A healthy private sector must be profit-driven. Profit is also, in economic terms, the soundest test in practice of the use of resources. Good development is not promoted by supporting private enterprises that are not profitable.
In another, more practical sense, because we work in partnership with businesses, we have to share their objectives, and their risks. That is a special characteristic of IFC. Our projects are not covered by government guarantees.
Although it is not our main objective to keep pushing for higher profits, a sound net profit for IFC is very good for the institution. For one thing, a healthy profit enables us to do a lot of borrowing in the markets on very good terms. It is also a safeguard against unforeseen difficulties. With a $100 million profit a year we probably have a good enough cushion. Further, a solid profit enables IFC to do things which may not appear to be profitable, at least in the short term. These include taking a longer-term approach to development. For example, we have launched a number of initiatives that will build the basis for profitable and developmental projects and enterprises.
IFC, poverty, and Sub-Saharan Africa
The direct attack on poverty in its extreme form is not our chief task. But we do help, by creating productive employment. No one pretends that IFC’s mandate is the whole business of development. We are only one player in a play with many other actors. The role of assisting governments to build up the right infrastructure, for example, is not our mandate.
In Sub-Saharan Africa, in addition to our normal type of activities, such as project lending and equity investments, we have begun, in the last two or three years, to develop special methods for helping these countries. We feel these methods ought to focus on helping small and medium-sized companies. We have done two main things.
First, we have set up, with the help of a number of aid donors and with the co-sponsorship of the United Nations Development Programme and the African Development Bank, a technical assistance organization, the African Project Development Facility. This Facility has now been working for nearly two years, with regional headquarters in Abidjan and Nairobi. We have teams of eight professionals in each of these offices. They provide advice to companies planning investments and help them raise finance. The two regional offices do not, themselves, provide capital. The demand for the services provided under the Facility has been extraordinary. They have so far helped over 20 companies to raise finance and are working with more than 100 others now. They have received almost 1,000 applications. Clearly, we should consider enlarging this Facility because it seems to have been such a success.
The second activity in Sub-Saharan Africa is much newer. In the autumn of 1988, our Board of Directors decided to set up a new Fund, the Africa Enterprise Fund (AEF), which we will administer as a part of IFC. To put this into effect, we are going to send many more people into the field in Africa and delegate them authority to take decisions autonomously, on much smaller investments than IFC usually makes. The normal minimum for IFC’s own investment in a developing country project is about $1 million. AEF investments will be in the $100,000–750,000 range. However, they will be subject to the same standards of analysis and techniques that IFC uses elsewhere.
This approach is an alternative to using local financial intermediaries. The record of intermediaries in Africa is not a very happy one. There have been a lot of unsuccessful development finance institutions. Good intermediaries are still hard to find. Where we can, we do use them—for example, an excellent company called IPS (Industrial Promotion Services) in Kenya which is partly owned by the Aga Khan Foundation. But where we find that there are no adequate intermediaries we should develop our own direct method of reaching smaller businesses.
MIGA and IFC
Both IFC and MIGA decided from the start that we should work together very closely. There is a degree of overlap in our work, not with the guarantee functions of the Multilateral Investment Guarantee Agency, but in its role of promoting foreign investment, which is written into its Charter. IFC has for quite some time been advising governments on how to attract foreign investment. We created a small unit called the Foreign Investment Advisory Service in IFC a couple of years ago to do that work more systematically. We are now discussing with MIGA the possibility of a joint advisory service which would be supervised jointly by senior IFC and MIGA staff and initially be staffed by IFC officials already involved in this activity.
Promoting equity investments in LDCs
The general aim of IFC is to facilitate the flow of capital and to help create new forms of capital flows to developing countries. We have, so far, been successful in helping increase portfolio flows, chiefly through portfolio funds such as the Korea Fund in the New York Stock Exchange which is invested in Korean stocks. IFC has promoted about nine such funds and the fashion has caught on. A number of other institutions have launched similar funds. In promoting developing country portfolio funds we have been conscious of the fact that in several Asian and Latin American developing countries, despite their problems, there are many companies that are strong enough to raise capital by issuing securities on one of the major world markets. Such securities may include bonds; one of the many short-term instruments, such as floating rate notes or Eurocommercial paper; or stock. But these companies have not tapped the developed country markets for investment finance. One reason is that there is an information gap, between potential investors and investment opportunities. We think there is a real job to be done in helping to close this gap and in bringing some of these developing country companies to the major markets.
IFC will perform the task of introduction and underwriting, normally in association with an investment or merchant bank in New York, London, or Tokyo. We have talked about this venture with a number of banks and they are quite eager to cooperate with us.
Size of institution
We have achieved the expansion in our activities in the last three or four years with a very small increase in staff. We may need more staff in the future but we have attempted to improve our internal efficiency. Fewer decisions are now taken by top IFC management and more decision making is delegated, chiefly to the heads of investment departments. We have generally tried to streamline our administrative process and make ourselves less bureaucratic, and with some success.
At a different level, our Board also took a decision recently to delegate considerable authority to the management to make decisions on smaller investments, thus speeding up the appraisal and approval process. In future, all loans under $25 million and equity investments under $10 million will be decided upon by management, unless there is some special problem or issue which ought to be brought to the Board. For Africa, the numbers will be different and somewhat smaller. As a result, about one half of our investments in future will be approved by management. Under the new arrangement we will provide more comprehensive reports on our work to the Board. The Board will be able to supervise our work, not by examining the minutiae of every project, but by taking a more general view of our activities. This development is very constructive and ought to help make us more efficient.
Relationship with the World Bank
The Bank is our big sister and the organization that first created us. Our relations with it are very important. The relationship has been changing in a paradoxical fashion. On the one hand, we are a little more independent of the Bank in the sense that we now raise most of our borrowed funds on the market rather than from the Bank as we used to do. On the other hand, we are more conscious of the need to cooperate more closely with the Bank. The IFC does not exist simply to make profitable deals, but to serve a development purpose and for that we need to fit our strategy into the Bank’s strategy. We have strengthened our links with the Bank as to planning operations. As a result of the report of the Knapp committee—set up by Mr. Conable to review the Bank Group’s activities relating to the private sector—we will more closely coordinate our activities with those of the Bank. In this way, when our investment department directors are working out their lending and investment strategies for major countries for the next year or two, they will do so in consultation with their opposite numbers in the Bank.
Yet our work is different. In dealing with the private sector one cannot program one’s activities in quite the same way as one would when dealing with governments. It is important to be responsive to the opportunities that exist and what businessmen are prepared to do at any point. But one must always maintain a sense of priority for what is to be achieved. In that context we hope to have better coordination with the Bank in the future to better meet the broader development needs of our member countries.
Looking back … and forward
A few years ago IFC appeared to have got rather stuck, in the sense that its methods and organization were the same as, say, 25 years ago, even though the scale of its activities had grown much larger. It was too exclusively a project finance organization, and it had perhaps become a little too bureaucratic.
When I first came to IFC, I spent a lot of time examining, together with the staff, the future role of the institution. Many ideas emerged from the staff. One of them was that we really should be an investment bank, that is lending money and assisting enterprises in raising money.
As to my contribution to the institution, if anything, I would like to be thought of as the leader of IFC who helped liberate the organization from some of its old intellectual shackles and moved it into a process of continuing change—change has to be evolutionary not revolutionary and it has to be continuous. I would like to be thought as having helped IFC to be more responsive to the needs of our members and to be more flexible and adaptable in its operations.
The Private Sector and the Policy Environment
Prospects for private business and foreign direct investment have improved in developing countries with changes in macroeconomic policies
Guy Pfeffermann and Dale R. Weigel
After decades of growing state involvement in development and, in some countries, government hostility to private foreign investment, many developing countries have begun reversing their policies during the past few years. As a result, the framework for private firms, both domestic and foreign, in a large number of countries has considerably improved.
The serious fiscal crisis which many developing countries now face is one of the important reasons for the policy shift from public to private provision of goods and services. Increased scarcity of resources has made it more difficult for governments to effectively implement proposed policies. Many governments have recognized that those countries which have had excessive state involvement in the economy have performed less well, in terms of economic growth and efficient use of resources, than those which have permitted a more active and larger private role. Hence, there has been a shift in policies in favor of the private sector to provide these services more efficiently.
These policy changes are an integral part of the structural adjustment programs which have been adopted by several countries with the assistance of the IMF and the World Bank. The general objectives of these policy changes are: greater efficiency in resource use by removing price distortions; increasing the scope for competition and market forces in the allocation of resources; and introducing a system of relative prices and a structure of incentives that reflect more accurately the scarcity of domestic and external resources.
Introduction of these measures can involve considerable reallocation of resources and restructuring of enterprises in the private as well as the public sector. As a result, they can involve much dislocation and disruption for private sector firms and enterprises; those which were previously protected under the old policy regime can face serious problems of restructuring. At the same time, these measures will benefit those enterprising firms that adjust well and take advantage of the new opportunities available. This article discusses some of the measures that have been taken, and the challenges and opportunities they present to the private sector. Particular attention is paid to recent trends in foreign direct investment.
In response to a general shortage of external resources, many developing countries have adopted programs that involve:
a revamping of the external trade sector (devaluation, import liberalization);
liberalization of controls in the domestic economy (price controls, investment licensing);
a move to economic pricing of inputs (e.g., removal of subsidies for utilities, energy, fertilizers); and
a shift in the relative roles of the public and private sectors.
Real devaluation causes difficulties for firms which had borrowed heavily in foreign currencies in relation to their capital base, but at the same time, it makes exports and import-competing industries more profitable. Real effective exchange rates (i.e., nominal exchange rates adjusted for relative inflation and trade—weighted) have depreciated substantially between 1982–87 in 15 out of the 17 heavily indebted middle-income countries classified as such by the Bank.
As a result, Mexican non-oil exports have increased rapidly, with the share due to firms with some foreign ownership increasing from 30 percent of the total in the early 1980s to 60 percent of non-oil exports more recently. Chilean agriculture and agri-business exports have increased by 60 percent over the past three years, reaching about $800 million in 1987. Opportunities for the private sector also have opened up in Africa, following devaluations in a number of countries (for example, in Ghana and Nigeria). Non-oil exports have been increasing since the adjustment program was introduced in Nigeria, and some previously smuggled products are being exported through official channels.
Trade liberalization, which has often been combined with devaluation in many adjustment programs, involves a gradual reduction of quantitative restrictions on imports and exports. Import restrictions have been replaced by tariff protection, with reduced and more uniform tariff levels, linking domestic prices more closely to foreign prices. Trade liberalization has been legislated in a number of countries including Bolivia, Chile, Ghana, Republic of Korea, Morocco, the Philippines, and Turkey—and has been effectively implemented in Nigeria. The immediate effect of trade liberalization is to expose the domestic private sector to import competition. However, at the same time, the freer access of local firms to higher quality imported inputs makes it possible to expand import-competing manufactures as well as manufactured exports.
Deregulation improves the business climate by giving a greater role to market forces and by reducing the incentive for lobbying, getting goods on the black market, and negotiating with government over licenses. Several countries have created “one stop” agencies to handle all necessary approvals, where previously several administrative agencies were required. The relaxation of price controls goes against those firms which previously benefited from artificially cheap inputs such as energy; however, many firms profit by selling their product at higher prices. Financial sector liberalization increases opportunities for private firms by reducing credit rationing through freer interest rate determination, and hence allows firms to obtain credit for bolder ventures. Reduction in licensing requirements for new investments also is generally welcomed by the private sector, even though in this case less efficient firms will be adversely affected by freer entry.
Privatization also creates new business opportunities and has been included in the structural adjustment efforts of a majority of developing countries undertaking such programs. It can consist not only of the sale of public assets but also of the transfer of management through leasing or management contracts, or contracting out public services to the private sector. Privatization may also take the form of a withdrawal by the public sector from such areas as urban bus services, hence enhancing the role of the private sector by providing new opportunities to entrepreneurs (see articles by Richard Hemming and Ali Mansoor, and Mary Shirley, Finance & Development, September 1988).
Challenges and opportunities
Private firms vary in their response to structural adjustment policies. Some may respond initially by financial restructuring of their enterprises, which may involve accumulating accounts payable, deferring debt obligations, or liquidating some short-term assets. As companies begin to believe in the permanency of the new structural adjustment measures, they may go further and take advantage of the new opportunities created by devaluation and trade liberalization by attempting physical restructuring through the adoption of new product lines or processes, and the elimination of others that are less profitable. Once full credibility of the government’s efforts at structural adjustment is established, private entrepreneurs may undertake completely new projects, some of which may have long gestation periods.
In Latin America, the highly indebted countries, except for Peru and Venezuela, have gone through the process of financial restructuring, punctuated by numerous bankruptcies. Physical restructuring is well underway in Chile, Jamaica, and Mexico. New projects involving considerable investment are being undertaken in Chile, Colombia, and Venezuela. In Venezuela, while the overall process of adjustment has only just begun, the contraction in oil revenues has led to the promotion of non-oil exports and import-competing industries. In Brazil, in spite of the unsettled course of the economy, there are indications that years of low levels of new investment have resulted in capacity constraints in a number of sectors, and selective new projects are being implemented.
In Africa, restructuring is being implemented in Ghana and Morocco—where new investment in manufacturing is being undertaken—and in Côte d’Ivoire. In Nigeria, since the reforms of 1986, companies have been better able to discern the long-run government policy framework which is likely to prevail and have planned for some new investment.
The favorable economic outlook for most countries in Asia has made business prospects attractive. The process of economic change in these countries has been more in the nature of continuous adjustment, in contrast to the more abrupt changes being made in other countries. Although the Philippines is one of the highly indebted countries, some investment for modernization, export, and increments to capacity is being planned. In Indonesia, the corporate sector is responding positively to trade liberalization and limited deregulation. In the Republic of Korea and Thailand private firms are seizing the new opportunities created by growth and economic success. Major new investment to meet the demands of the growing domestic market is being undertaken in Thailand.
In South Asia, structural adjustment has principally taken the form of deregulation, involving reduced licensing requirements, liberalized import policies, relaxed price controls, freer foreign investment approvals, and a greater role for the private sector in investment in the productive sectors. There has been a sharp spurt in private investment in both India and Pakistan. In India, the relaxation of government controls on entry into industry has created a new competitive environment for the private sector. Similarly, the entry of foreign investors into sectors previously discouraged has raised the quality of products in the domestic market and threatened the profitability of established manufacturers. Despite the short-run disruption caused by some of these measures, the longer-run impact on overall economic growth and on the ability of the Indian private sector to penetrate export markets is likely to be very favorable. The process of corporate restructuring has only just begun in South Asia. However, there is substantial scope for a continuation in the future.
Foreign direct investment
Some of the factors that have led developing countries to place greater emphasis on market forces have also led many countries to seek greater inflows of foreign direct investment. In particular, the decline in foreign capital flows (including direct investment) to capital-importing developing countries has led many of these countries to search for ways to increase foreign direct investment inflows. A growing confidence on the part of developing countries in their own ability to control abuses and to take full advantage of what foreign investors may have to offer is another factor that has led to increased interest of developing countries in stimulating increased inflows of direct investment.
This change of attitude has led many countries to liberalize their policies toward foreign investment. In Sub-Saharan Africa alone, for example, more than 20 countries have revised their investment codes since 1982 or have introduced new ones. As a result of these liberalizing trends, restrictions on the sectors in which foreign investment is permitted have been eased, as have those on the proportion of owner’ship open to foreign firms; the procedures for screening applications have been streamlined; the incentives offered have been made more transparent; and the rules governing repatriation of profits have been liberalized.
A number of countries in Latin America and the Caribbean have now eased entry restrictions. Several Caribbean countries have either enacted new investment laws or have amended the existing ones. In Argentina, oil exploration and exploitation have been opened to foreign investors, and the Government is considering foreign equity participation in the sale of the national telephone company. Decision 220 of the Andean Pact (May 1987) allows member countries to regulate the sectoral entry of foreign investment at the national level rather than the more stringent regional restrictions that had been in effect. Several Asian countries too have widened the area open to foreign investment. In Korea, 80 percent of the industrial sector is now open to foreign investment compared to only 50 percent in 1980. Indonesia, Malaysia, and Yugoslavia have also increased the number of sectors in which foreign participation is allowed. However, the trend has not all been in one direction; Brazil and Argentina, by contrast, have recently intensified their restrictions on entry into certain sectors, most notably in electronics, and, in the case of Brazil, mining and oil exploration.
Most countries have procedures for screening applications for foreign investment, and where these have been excessively cumbersome and complex, they have often proved to be a critical deterrent. To save investors from having to obtain approval from several different government authorities, a number of countries—including Korea and Yugoslavia—have instituted “one-stop” agencies, and others such as Ghana and Kenya are in the process of doing so. A system of automatic approval for certain types of investment projects has been introduced in some countries (e.g., Korea and Venezuela), while various application forms and licenses have been simplified in others (e.g., Indonesia, Mexico, Yugoslavia). However, the way in which the screening is actually carried out does not always conform to the rules, and in a number of countries administrative practices may be more or less flexible than a literal reading of the law would suggest.
Another encouraging trend has been the relaxation of rules governing the share of enterprises which may be owned by foreigners and the extension of periods over which the foreign investor is allowed to maintain its participation before selling out to a domestic partner. New rules in Ghana, Mexico, the Philippines, and Yugoslavia have increased the share of ownership which the foreign investor is allowed; in Yugoslavia, for example, a majority interest is now acceptable. In some countries even 100 percent foreign ownership may be permitted under certain conditions: in Malaysia, if the enterprise exports 50 percent or more of its output and employs 350 full-time Malaysian workers; in the Philippines in certain specified areas and in ventures exporting at least 70 percent of their production; in India, where the entire output is exported. China and Hungary also allow 100 percent foreign ownership under limited conditions, usually when the investing firm has technology of special importance to the host country.
The question of whether investment incentives, particularly tax incentives, are a cost-effective instrument for encouraging foreign investment has been much debated. Most studies report that most investment decisions are not affected by fiscal incentives (e.g., reduction of taxes on profits). While some countries, such as Indonesia and Korea, have abolished or reduced the tax incentives given to foreign investors, others have introduced a whole new set of fiscal incentives. Countries in this category include China, Ghana, Guinea, India, Madagascar, Thailand, and Yugoslavia.
Restrictions on the repatriation of profits have been a powerful deterrent to foreign direct investment, particularly in countries subject to chronic balance of payments difficulties, where foreign exchange allocations for this purpose are liable to be cut off altogether. Korea has recently abolished restrictions on the repatriation of capital by foreign investors. In China, where foreign investors are usually obliged to balance their foreign exchange earnings and expenditures (including the transfer of profits), the regulations have recently been modified in ways which make repatriation somewhat easier. Colombia and Venezuela are other countries which have moved in the same direction.
Partly in response to these changes, direct investment in capital importing developing countries increased in 1987 for the first time since 1983. Nevertheless, much more needs to be done to attract foreign direct investment, particularly to the heavily indebted middle-income countries. Debt/equity conversion schemes, which give foreign investors an up-front discount on the cost of their investment while also permitting the host government to prepay some of its foreign debt at a discount, are one of the more promising ways of promoting direct investment in highly indebted countries. Research by IFC’s Foreign Investment Advisory Service (FIAS) has shown that such debt/equity swaps have had a significant favorable impact on direct investment, particularly in Chile and Mexico and particularly for export-oriented projects (see “The Impact of Debt to Equity Conversion,” by Michael Blackwell and Simon Nocera, Finance & Development, June 1988 and “Debt-Equity and Foreign Investment in Latin America,” IFC Discussion Paper #2, August 1988). Argentina and the Philippines also have established conversion schemes and Brazil has recently re-established a swap program.
A significant change has taken place over the past few years in most developing countries, as governments have come to rely much more now on private enterprise as an “engine of growth.” This change in attitude is reflected in an increasingly liberal business environment, which has created new opportunities for domestic as well as foreign entrepreneurs. The current economic situation in many developing countries may lengthen the time necessary for such policies to have a substantial impact on private investment. Nonetheless, if coupled with appropriate macroeconomic policies, both in the industrialized and developing worlds, this new environment could provide opportunities for more rapid growth in developing countries.
Emerging Stock Markets in Developing Countries
Although volatile, these markets offer global investors an opportunity to diversify their portfolios
David Gill and Peter Tropper
Global investing is far from a new idea. Foreign portfolio investment started in London and Amsterdam in the late 17th century. The first foreign portfolio investment involving North America was the “limited partnership” of Spanish investors, headed by Queen Isabella, who financed Christopher Columbus’s voyages. Cross-border portfolio investment flows from Europe helped in the economic development of North and South America, as well as many parts of Asia.
The reasons for and objectives of foreign portfolio investment are the same today as centuries ago: the supply of savings increases faster than the emergence of profitable investment opportunities in domestic markets while better investment possibilities emerge abroad. Such a situation has resulted in increasing geographical diversification from Europe and the United States into emerging stock markets in developing countries where such investments have helped to provide much needed equity capital. In the wake of the debt crisis of the early 1980s, the importance of growth-oriented adjustment strategies came to be keenly recognized and supported in both developed and developing countries. Flows of external equity capital play an important role in this process.
Equities markets and development
A strong, healthy equity market can benefit a country’s economic development in several ways:
It contributes to the stability of a country’s financial system and economy to the extent that it reduces the vulnerability of companies to floating and high real interest, rates. External debt financing requires payments even when companies are losing money. Equity financing, in contrast, permits firms to adjust payment levels to suit their needs. At the same time, it provides permanent finance.
It helps promote growth and employment by providing finance for small businesses both directly, through a country’s larger formal markets, and indirectly by making venture-capital operations more feasible in the more advanced developing countries. The value of small businesses has been amply demonstrated in developed countries, where they have proven that they can produce more jobs, more innovation, and more tax revenue relative to investment than larger firms.
It eventually promotes democratic ownership of industry by distributing the ownership of securities more widely among the public.
It can make access to international capital easier to the extent the market develops into an efficient and liquid securities exchange. (The existence of a stock market does not, by itself, give companies access to capital. It does allow securities to be traded, providing a market valuation of existing issues, thereby indicating receptivity and possible prices for new issues. Thus it fosters the development of a broader capital market.)
A formal and well-regulated market can increase economic efficiency by establishing fair prices for securities and by minimizing the costs of buying and selling them. By properly supervising new issues and by requiring full disclosure of relevant financial information, a well developed securities market can protect investors against unfair practices. A market with active trading also enables investors to Adjust their portfolios quickly without having to hold large cash balances.
Until recently, the potential of direct equity investment (that is, participation in both ownership and management of businesses) in developing countries received relatively little attention. Short-term debt finance was often available on attractive terms from local banks for long-term project financing, as was long-term finance from development banks through credit allocation to priority sectors. Interest rate subsidies and tax deductibility of interest payments favored debt financing over equity for corporations that were able to borrow. Negative real interest rates, which for long periods were commonplace in many developing countries, lowered the cost of debt finance for companies in priority sectors; this indirectly taxed savers and discouraged savings mobilization.
Even less attention was given to the possibilities offered by portfolio investment, in which investors purchase a minority of shares in several companies as part of a strategy to diversify their holdings, but make no attempt to influence management. Chief among the advantages of such investment for developing countries is that portfolio investment—with due safeguards against foreign takeovers—can introduce new sources of equity capital without diminishing domestic control. One reason that portfolio investment was overlooked was the absence of domestic institutions that manage portfolios in developing country capital markets. Another reason is that portfolio investors are typically passive, remaining more interested in diversifying than in controlling the management of companies. At the same time, the principal institutions of the capital markets in developed countries that could invest in developing country markets—such as, pension funds, insurance companies, unit trusts, and mutual funds (investment trusts)—have tended to ignore developing countries.
Growth of emerging markets
An increasing number of developing countries—the more advanced and newly industrializing countries in particular—have begun to recognize the advantages of an expanded domestic securities market for their economies. By the end of 1987, the largest stock markets in 19 developing countries had grown to an aggregate total market capitalization of about $180 billion. Some of these emerging markets are comparable in size to the smaller European markets, and many of these have been growing at a much faster rate than European markets over the past decade and are likely to continue to do so. For example, the markets of Brazil, India, Malaysia, and Mexico were larger than those of Austria, Israel, and Norway at the end of 1987.
The IFC emerging markets Indexes
Sources: IFC Emerging Markets Data Base; and Morgan Stanley-Capital International.
Note: All indexes are converted to US dollars at the end of each period with December 1975 = 100. The indexes are equally weighted and are converted monthly. The IFC indexes are shown with dividends reinvested in the issuing stock. The Morgan Stanley-Capital International index assumes that dividends are reinvested in the basket of stocks.
1 The Amman Financial Market began operations in 1978.
During some years in the 1970s, Argentina, Brazil, Chile, Jordan, the Republic of Korea, Mexico, and Thailand experienced annual growth rates of more than 100 percent in trading volume and market capitalization even when measured in terms of the US dollar. In most cases, such growth was well ahead of inflation and the expansion rates of the respective economies in real terms, and was much higher than growth in many European stock markets over the same period. In many developed countries, however, these markets showed considerable short-term volatility of prices rather than a uniform upward trend. But the overall growth during the 1970s was considerable.
In countries such as Indonesia, Jordan, the Republic of Korea, Pakistan, and Thailand, the number of companies listed on the markets has grown substantially, often as a result of special government efforts. More established markets such as those in Hong Kong, India, Singapore, and most Latin American countries expanded not so much because of increases in the number of listed companies, but because of the increase in the market value of the companies already listed on those exchanges.
During the 1980s, the experience of emerging markets has been more mixed and often disappointing. The debt crisis at the start of the decade led to a slump in corporate profits and a weakening of many national economies. This was particularly true for Latin America, where high inflation rates, overspending by governments, and a slowdown in growth contributed to foreign exchange and indebtedness problems. Domestic investors’ confidence waned while stock prices declined, in nominal terms as well as after adjustment for inflation and devaluation.
Most Asian markets fared better, although recent performance has fallen short of the high growth and excellent returns achieved during most of the 1970s. Markets in India, Indonesia, Korea, Malaysia, and Pakistan have been active and growing, and the Thai market has finally recovered from a collapse following a speculative boom in 1977–78.
A look at total return indexes over 12 years for 10 emerging markets shows that although developing country stock markets are extremely volatile, they yield high rates of return (see charts). This is true even after allowing for foreign exchange fluctuations. Markets in Chile, India, Korea, and Mexico have generally produced greater returns than both the Morgan Stanley-Capital International World Index, the most commonly used performance measure for developed markets, and the Standard and Poor’s Composite Index of 500 stocks for the United States.
In the past four years, the emerging markets as a group attracted about $2 billion of portfolio investment from developed countries. During 1987. which included the crash of October 19, the World Index increased by 14.3 percent and the S&P 500 rose a meager 0.4 percent. Some emerging markets, such as Brazil, experienced particularly sharp downturns in 1987 but, to a large extent, this was because of domestic factors and was unrelated to the October events in the main markets. Interestingly, while the US market fell 23 percent from its 1987 high to the end of March 1988, several emerging markets registered increases: Zimbabwe, 32 percent Korea, 31 percent; Jordan, 5 percent; and Venezuela, 4 percent. During the same period, Japan’s market rose 9 percent.
Why foreign portfolio investment?
In the past few years, portfolio investors in the capital-exporting countries have become much more interested in international diversification to guard against currency risk and fluctuations in the economic performance of individual countries. A significant proportion of equity portfolios of such institutional investors is already diversified within the developed countries. In part, this resulted from the rapid growth of pension funds and mutual funds in the United States, Europe, and Japan. International money managers, guided by the need to diversify risk and seek higher returns, have been moving into new markets and stocks.
IFC’s role in encouraging foreign portfolio investment
How is the International Finance Corporation, the World Bank affiliate with 132 government shareholders and financial resources of approximately $2 billion, involved in encouraging the flow of foreign portfolio equity investment to promote economic development?
First, IFC’s mandate is to promote the private sector of developing countries by investing in commercially viable, expanding companies and by advising its shareholder governments on private sector and financial market development issues. IFC is a major direct investor in equity securities with over 300 equity investments in 68 developing countries, for a total of the equivalent of over $500 million as of June 30, 1988.
To support the development of domestic equity markets and their eventual access to international markets, IFC has developed a broad strategy encompassing the following:
Technical assistance to governments to help them develop their domestic securities market infrastructure and mechanisms. These activities expanded substantially in the late 1970s and early 1980s to include policy advice and technical assistance to the governments of some 70 developing countries. Through its work with ministries of finance, central banks, securities commissions, and stock exchanges, IFC encourages sound investor protection policies and practices and the establishment of a variety of financial institutions.
Promotion and establishment of national and regional investment banks and other securities companies. These institutions complement improvements in financial infrastructure and work toward a more efficient marketplace. They also can bring domestic securities issues together with foreign investors, providing necessary information and market expertise at international standards. IFC, in conjunction with foreign technical partners, has invested in some 20 securities companies and venture capital companies.
Support for the concept of foreign portfolio investment in developing countries by developed country institutional investors, such as pension funds and insurance companies. IFC has expanded its work with foreign capital market institutions to build knowledge and receptivity to investment in selected LDCs. To this end, it has created the Emerging Markets Data Base, with information on stock markets and more than 400 companies in developing countries. Earlier this year, IFC began offering the data as a commercial service to clients to increase interest in international portfolio investment.
Participation in country equity funds. IFC has participated in private placements in several major markets and has underwritten some 40 domestic private securities issues in developing countries. In 1984, IFC was a co-lead manager for the non-US portion of the Korea Fund issue, which is listed on the New York Stock Exchange, the success of which led to the issuing of a second tranche of this Fund in May 1986.
IFC acted as a lead manager of the public offering of the $30 million Thailand Fund, listed in London in December 1986, as co-lead manager of the public offering of the $84 million Malaysia Fund, listed in New York in May 1987, and as a lead manager of the public offering of the $100 million Thai Fund, listed in New York in February 1988. In the last year, IFC helped arrange an $87.5 million private placement fund in the United States for new portfolio equity investment in Brazil, along with six major US pension funds. IFC was also a sponsor and key investor in the multi-country Emerging Markets Growth Fund (EMGF). This fund was established in May 1986, with initial capital of $50 million. Its investment objective is growth of capital through investment in securities listed in the stock exchanges of developing countries. At the end of December 1987, this fund was invested in nine developing countries.
In light of the successful performance of the EMGF, IFC launched a second multi-country fund specifically targeted to Japanese institutional investors in February 1988. This fund serves as a mechanism to facilitate the recycling of Japan’s current account surplus to developing countries. The marketing of this Emerging Market Investment Fund was conducted against a background of turmoil in stock markets since October 1987. Still, the fund attracted $43 million in subscriptions from investors. The fund’s size is expected to increase over time as market conditions continue to improve.
At present, IFC is working on a number of other investment fund transactions—involving both new cash and debt conversion schemes—as well as on several corporate bond and equity issues. It plans to launch a debt-equity conversion fund in Chile and a similar scheme in the Philippines. As favorable conditions develop, it also expects to develop such funds in other countries of Latin America, Asia, and Africa.
A pool of funds, estimated at over $2 trillion and growing at about 15 percent annually, forms the investable resources of pension funds, insurance companies, trust funds, and investment companies based in the capital-exporting countries. Among the over 8,500 stocks traded on the equity markets of the developing countries are some 300 which meet the general financial, liquidity, and “visibility” criteria for investment expected by international portfolio managers. Many of these markets are relatively undervalued, with price-to-earnings ratios well below those of the markets of the leading developed countries.
Modern portfolio theory states that portfolio diversification is crucial to achieving maximum returns for an acceptable level of risk. Though emerging markets fluctuate to varying degrees against the US market, some tend to move in opposite directions from the Standard & Poor’s Composite Index, producing good returns when the US market falters. Consequently, investments in emerging markets may enable portfolio managers to reduce risk for a given level of return and occasionally to reduce risk while increasing returns.
LDCs and portfolio investment
To the extent that international portfolio investors want to participate in emerging markets, it follows that these countries and especially the companies in those countries seeking foreign capital should benefit if the investment is to be a fair deal for both sides—the essential prerequisite for a longterm beneficial relationship.
Many developing country corporations have outgrown their apparent domestic capital markets and would benefit from the purchase by foreign investors of new stock and long-term convertible bond issues. Such purchases by foreign investors of outstanding stocks on developing country stock exchanges sometimes expand the local market by leading to an increase in the demand for those stocks by domestic savers.
The process of investment by foreigners may also involve transfer of know-how in business techniques. Since foreign investors have a wider range of investment alternatives, they tend to focus on highly productive investments and to seek the securities firms in developing countries that offer the best facilities for research and processing of their orders. Active foreign interest in emerging securities markets can bring sophisticated company, industry, and economic analysis techniques into these markets and generally could contribute to increasing the efficiency of capital allocation in the economy.
A good example is Korea in the 1980s. When the Government first opened the equity market to foreign investors, initially through the issuance of closed-end investment trusts, foreign investors could at last participate in the growth potential of the country by sharing in the profits of local enterprises. The Government’s next step was to permit major Korean companies to issue convertible bonds to foreigners, which allowed them, in effect, to sell stock in the international capital markets. This process began in 1987, when several convertible issues became eligible for conversion and others were negotiated. The most recent issue carried an interest rate of less than 2 percent, proving that companies in these countries could not only increase their access to foreign funds but also significantly reduce the cost of such funds.
Foreign portfolio investment is not without some drawbacks. In almost all circumstances, a professional portfolio investor will sell stock if a company’s performance has fallen below expectations. This raises the possibility that foreign portfolio investments could become volatile and flow suddenly in and out of a stock or an entire stock market. This has implications, not only for individual firms, but also for the balance of payments of the developing countries subjected to such volatile movements, if funds are repatriated out of those developing countries.
At the country level, this risk can be reduced by restricting foreign investments to either “closed-end” investment trusts, where the foreign shareholder can sell only to another foreigner, or by establishing a specific class of common stock to be owned by foreigners which, once bought, can be sold only to other foreigners unless the local authorities decide otherwise. These techniques allow only a specified amount of foreign portfolio funds to enter the domestic market. The invested capital remains in the country while only earnings and capital gains are repatriated.
Another perceived potential disadvantage is that foreign portfolio investment can turn into a form of “creeping control,” as foreigners buy out domestic shareholders over time until, as a group, the foreigners gain control. This can be eliminated by limiting the total percentage of the outstanding capital permitted in the hands of foreigners, or by limiting the total percentage of shares that foreigners may vote at shareholders’ meetings.
For example, in permitting foreigners to invest in Korean stocks through special funds, such as the Korea Fund, the Korean government restricted each fund’s investment to no more than 5 percent of a class of stock in any one Korean company and all foreign investment in the same stock to no more than 10 percent. Further, a foreign investment fund cannot invest more than 25 percent of its assets in stocks of any single Korean industry. As an alternative, the Philippines and Mexico have used two classes of common stock, identical in all respects except that one of the two classes may not be owned by foreigners, effectively limiting foreign control.
The benefits that equity markets can potentially bring to economic development are often overlooked. Since the debt crisis of the early 1980s more attention has been paid to equity investments as a source of development finance and to the contributions that foreign portfolio investment can make. Though foreign ownership of domestic assets raises important policy issues for governments in developing countries, experience with a variety of approaches suggests that strong equity markets can accommodate foreign investment and play a useful role in economic growth strategies.
Capital Market Development
Helping IFC member countries with technical assistance, investments and loans, and access to global markets
Charles O. Sethness
Director, Capital Markets Department, IFC
Strong financial markets are fundamental to economic development. Without them, a country lacks the ability to mobilize the financial resources and skills needed for modern investment activity. Conversely, thriving capital markets are often closely associated with vibrant private sector development and strong economic growth, as experience in the Republic of Korea and Thailand illustrates.
The gross investment requirements of the developing world have been estimated at some $600 billion a year. The bulk of these needs can only be met from domestic savings. Particularly in these days of internal and external debt problems, higher domestic savings rates and the efficient channeling of resources into productive equity investments are preconditions for accelerating economic growth. As a result, a growing number of developing countries have been undertaking programs to develop their financial markets, as well as to attract more inflows of equity capital from abroad. Such programs aim to create a legal, fiscal, and institutional framework conducive to increasing the volume and efficiency of the flow and allocation of financial resources. They usually include the creation of new, and the strengthening of existing, financial institutions.
Capital Markets Department
IFC’s Capital Markets Department acts both as an adviser and as an investor in developing financial systems. Established in 1971, it provides comprehensive assistance for the development of financial markets, including advisory services, investment and financial support for local financial institutions, and sponsorship, structuring, and investment for local companies or entities seeking access to international capital markets. These activities are carried out in close collaboration with the other IFC departments and the World Bank, and complement the Bank’s work on the financial sector in member countries and its advice to governments on financial policies.
The Department has undertaken more than 350 investment and advisory projects to improve resource mobilization for private sector development in more than 70 countries. Most of these operations concentrate on fostering growth in domestic financial markets; some of the recent ones focus on promoting access to international capital markets.
The goals and instruments of the Department’s assistance to capital markets are influenced by the state of development of the member country in question. In a country in the early stages of development, the goal is often to encourage the growth of longer-term savings so as to allow the orderly growth of longer-term investment. IFC will often further this aim by supporting new institutions such as housing finance companies and, in recent years, insurance companies, while the financing of capital goods for small- and medium-sized enterprises is fostered through the creation of leasing companies.
In middle-income countries, increased demands on the financial system frequently bring about rapid evolution as financial institutions grow in number and become more functionally diverse. Thus, IFC’s programs in these countries usually concentrate on promoting the growth of securities markets and diversifying the domestic and foreign sources of investment finance. Attention is normally given to the fiscal and regulatory environment, the improvement of corporate financial reporting and disclosure, and the promotion of specialized financial institutions or services. These specialized institutions may include stock brokerage and money market firms, investment and merchant banks, and specialized leasing companies that emphasize specific services such as mediumto long-term financing for domestically produced equipment.
As the pace of capital formation accelerates with economic growth, the demand for long-term funds increases dramatically and financial markets become more sophisticated. Thus, in higher-income developing countries, IFC’s capital markets program typically has such goals as (a) broadening the ownership of business enterprises and bringing more issuing companies and individual and institutional investors into existing domestic and international securities markets and (b) broadening the range of available financial services. These goals are pursued through, for example, establishing specialized institutions such as venture capital companies, specialized investment and merchant banks, mutual fund or unit trust management companies, and export credit banks. Other methods include mobilizing foreign resources by assisting financial institutions and financial enterprises to gain access to international capital markets, and increasing the knowledge and experience of foreign portfolio investors in domestic markets.
IFC’s capital markets activities fall into three main groups:
providing advice and other services to help establish and strengthen capital markets and related institutions;
strengthening domestic capital market institutions through investment or lending; and
improving access to world financial markets.
Typically, IFC’s assistance for financial market development includes technical assistance, which is often accompanied or followed by institutional investments. IFC assists government authorities to formulate capital market development plans, establish an order of priorities, create appropriate legal, regulatory, and fiscal frameworks, and identify the needs and opportunities for specific institutions and market mechanisms.
When special needs are identified, IFC helps to design and create new institutions or reorganize existing ones. Institutions receive help on operational, organizational, and management issues and problems, as well as training for their key staff.
The process often starts with an in-depth review of the capital market. This addresses such questions as: Does the nation’s legal code permit development of the key elements of a financial market? Does the regulatory structure help or hinder market development? Are key institutions in place and functioning well? Does the financial system give equal incentives for the development of equity investment and for lending?
In this phase of work, IFC staff frequently work closely with staff of the World Bank. Recent examples of such joint activities include a privatization program for Nigeria, the design of venture capital policies for India, and a financial restructuring and debt conversion program for enterprises in Jamaica. Broad-ranging advice has been provided to countries with centrally planned economies, such as China and Hungary, which are seeking to develop securities markets, and to numerous countries that have sought advice on regulating securities markets.
One of the products of the technical assistance work of the Capital Markets Department is IFC’s Emerging Markets Data Base, which is now being marketed on a commercial basis. Designed to promote knowledge about the stock markets of developing countries, this is a unique, detailed, computerized data base on the most actively traded stocks, currently in 19 emerging stock markets. It offers information on stock prices, cash dividends, changes in capitalization, trading data, price/earnings multiples, book values, and more, in monthly time series on over 400 of the leading companies, often going back as far as December 1975. It provides monthly updates to subscribers, and is constantly expanding its country, stock, and company coverage. The IFC Emerging Markets Indexes are the only comparably prepared indexes on these emerging markets. The data base also has statistics on the performance and size of stock markets. IFC also publishes a Quarterly Review of Emerging Stock Markets and an Annual Factbook, which have been recognized as important contributions to the information available about these markets.
Investment in domestic institutions
To expand financial markets to provide a broader range of services, new financial institutions must be created and the services of existing ones expanded. Over the years, the Capital Markets Department has undertaken more than 150 investments (including rights issues) in merchant and investment banks, export finance enterprises, venture capital operations, housing finance, and leasing and insurance companies, the need for many of which was identified as part of its technical assistance work. In Portugal, for example, IFC helped to set up the country’s first leasing company, after providing extensive technical assistance on a new law and regulatory framework for equipment leasing. In Korea, four companies were created over time to implement new policies in money market and securities financing, equipment leasing, and venture capital financing.
IFC’s investments in this regard are often quite small in financial terms, with equity investments ranging from $200,000 to $1 million; IFC rarely subscribes to more than 10–15 percent of the equity of such institutions. However, it has an important catalytic effect in mobilizing finance from other sources, both domestic and foreign. This has been the case, for example, with the South East Asia Venture Investments Company NV (for venture capital investment in the ASEAN region) and the Housing Development Finance Company Ltd. in India.
Even more important is the demonstration effect that a successful first institution has. Whole new industries—for example equipment leasing in India, Indonesia, the Philippines, and Sri Lanka—have flowed from successful first projects.
Access to international markets
Severe debt problems worldwide have shown the need for greater use of equity and world securities markets in place of excessive reliance on bank loans. These circumstances make it urgent both to develop domestic capital markets further and to enhance access to international equity investors.
The Capital Markets Department has worked on improving capital flows to developing countries through international securities markets. This work includes:
sponsoring and underwriting closed-end portfolio investment funds whose shares are publicly traded in markets such as New York or London;
sponsoring and investing in privately placed ‘new money’ and debt conversion funds, for investment in both the stock markets and direct issues of new equity or government disinvestment programs in developing countries; and
arranging and participating in direct international issues by private enterprises from developing countries.
The most highly visible and publicized activity of the Capital Markets Department has been the extraordinary success of portfolio investment funds, which have helped a number of member countries and groups of countries to improve their access to world financial markets during the past three or four years. This activity was first launched with the Korea Fund in 1984 and has continued with six additional funds through mid-1988. Three of these funds are listed on the New York Stock Exchange, while one is listed on the International Stock Exchange in London (see box accompanying article by David Gill and Peter Tropper).
As well as cash funds, IFC has cosponsored and underwritten three debtequity conversion funds: the First Philippine Capital Fund L.P.; the Chile Investment Company; and Equitypar (Brazil).
Through all these funds, IFC has so far helped to raise more than $775 million in non-domestic equity resources for developing member countries. However, perhaps the greatest impact of these funds has again been in their demonstration effect. There are today over 35 investment funds for one or more developing country stock markets, representing new capital of over $1.6 billion, with many more in preparation.
IFC has also turned its attention to helping sound financial institutions and companies in developing countries tap world capital markets directly. For example, it recently established facilities to permit two Turkish commercial banks to enter the Eurocommercial paper markets; these are the first such facilities ever accepted for private sector borrowers in developing countries. IFC has also been lead manager for a series of floating rate notes for the Latin American Export Bank (BLADEX), producing the first new money from the international capital markets for a private company in Latin America since the onset of the debt crisis in 1982.
Looking to the Future
The demand for the Department’s services is expected to go on growing rapidly in future, both because of the general increase in awareness in member countries of the benefits of strong capital markets, and because of growing opportunities for collaboration with the World Bank, in its financial sector work and related sector lending.
The core of the Department’s operations will remain in strengthening domestic capital markets through advisory services and the promotion and support of institutions. Improving access to world markets will include new country and multi-country cash and debt-equity fund initiatives, further focus on helping individual companies gain access to international markets through stock, bond, or other securities issues, and expanding the number of users, and information available from the Emerging Markets Data Base.
Corporate Debt Restructuring in LDCs
Foreign debts of private enterprises can hinder their development and national adjustment efforts. How IFC helps reduce the debt burden
Peter C. Jones
While the Third World debt crisis, involving some $1 trillion in foreign debt, is mainly a problem of sovereign debt (i.e., debt owed or guaranteed by developing country governments), the foreign debt of private enterprises is also a leading issue in many of the major debtor countries. Such debt constrains private sector development, and critically affects the outcome of macroeconomic adjustment strategies favoring market-oriented growth.
The International Finance Corporation has worked to reduce private sector debt within the context of the World Bank Group’s overall efforts to help heavily indebted countries grow out from under their debt burden. It has followed a case-by-case approach to foster market-oriented solutions for reducing corporate debt in these countries. The goal of corporate restructurings of debt is to revitalize private sector industrial firms and restore their ability to invest and grow.
Corporate debt restructurings are included in IFC’s current Five Year Plan for fiscal years 1985–89 and represent a diversification of its investment activity in the Third World, beyond its traditional involvement with loan and equity financing of new projects. A good example of such work is IFC’s Mexico Capitalization Program for the Private Sector (see box). Here, as in other cases, IFC’s work in the private sector complements the
World Bank’s broader efforts of restructuring public sector enterprises and developing growth-oriented macroeconomic adjustment policies.
Issues of private debt
In developing countries the bulk of the private sector’s foreign debt was acquired by the more aggressive industrial groups for investments aimed at growth and diversification during the economic expansion of the late 1970s and the early 1980s. When the foreign debt was contracted, decisons were based on the best information of the time, which included an expected (but subsequently unrealized) path of key economic policy variables. The onset of the Third World debt crisis in 1982 brought about an abrupt contraction in domestic markets, major devaluations, and austerity in government spending. While the incidence varied with the degree of export orientation, many important industrial groups, some admittedly given to excesses in corporate acquisitions during the boom years, found themselves over-extended financially. They faced reduced cash flow prospects and an unsustainable amount of debt, mainly denominated in foreign currencies, while their physical assets and plants remained unchanged.
The resolution of private sector debt problems began very slowly, in part because of uncertainty about how long the depressed economic situation would last and in part because creditor banks generally regarded the available courses of action as unattractive. The options available to creditors included:
Liquidation of borrowers. The prospects for recovery of loans through the sale of companies appeared unpromising in many cases because of weak markets with few potential buyers and because bankruptcy proceedings could be costly and lengthy, with uncertain outcomes.
Sale or swap of loans. While helpful mainly for creditor banks with small exposures and for concentrating portfolio positions in more desirable credit risks, the sale of loans in secondary markets involves substantial write-downs (reductions in the values of loans). This option was generally viewed as unrewarding for creditor banks with large loans outstanding. Also, a shift in the holder of debt instruments offers no benefit to the indebted company.
Restructuring of loans. Many of the early loan restructuring efforts were no more than exercises in the rescheduling of maturities and the capitalization of accrued interest. Those arrangements tended to postpone the problem and severely hindered companies through restrictive covenants and controls.
The fact that large numbers of creditor banks (30, 40, or well over 50 in some debt restructurings) were forced to make difficult decisions on private sector debt, while at the same time participating in sovereign debt restructuring and new money packages, complicated the restructuring process. Delay in the resolution of corporate overindebtedness became a critical issue after 1982, with high costs for both firms and countries.
Costs of indebtedness
The continuance of unsustainable debt erodes business conditions in a number of ways:
Shareholders may eventually lose interest in the company and yet refuse to sell their shares at distress prices, thus contributing to further delay of remedial action;
Management of operations suffers as debt administration demands primary attention;
Plant integrity. As major maintenance and equipment overhauls are postponed, inefficiencies grow and the physical plant may be threatened;
Technological obsolescence. Upgrading is sacrificed; both efficiency and product quality gradually fall behind international standards.
Working capital rationing. Limits on investment in inventories and production systems may seriously inhibit a firm’s response to opportunities for new orders and increased plant utilization; and
Forgone investment. High yielding investments of even small size may be forgone, adversely affecting the firm’s ability to invest in additional production and employment.
The over-indebtedness of individual firms has important effects on macroeconomic adjustment strategies based on marketoriented growth. For instance in the case of macroeconomic policies such as the opening up of the economy, over-indebted enterprises cannot respond vigorously either to the increased opportunities for export production and sales, or to the threat of foreign competition within home markets. Similarly, over-indebted enterprises cannot further the cause of privatization. They are unlikely to be successful in mobilizing new capital or in providing managerial expertise for previously state-owned facilities. More generally, over-indebted corporations are unable to invest and expand in response to market opportunities, even in the presence of enhanced opportunities that may result from economic policy changes.
IFC has accumulated considerable experience in investing in Third World enterprises over the past 30 years or so. This experience and investment expertise has guided IFC in its approach to corporate restructurings and has helped develop a methodology which differs from that of the typical creditor bank—which understandably approaches the defaulting borrower strictly with a view to extracting repayment of the maximum amount of debt.
Corporate Debt Restructuring in Mexico
During the rapid economic expansion of the late 1970s and early 1980s, when Mexico had easy access to billions in the international capital markets, much of Mexico’s private sector expanded and diversified, funding this growth largely through foreign borrowings. Following the 1982 economic crisis and several substantial devaluations of the Mexico peso, domestic demand suffered a severe contraction and local sales dropped precipitously. Especially vulnerable were companies whose earnings were in pesos but whose debt was largely denominated in US dollars. These firms experienced large operational and financial losses and because borrowings became substantially larger while cash flow declined, companies that were otherwise viable found themselves saddled with unsustainable levels of debt.
Soon after the 1982 crisis Mexico’s private sector foreign debt amounted to as much as $18.5 billion. This compared to a total foreign debt of about $105 billion. Several major corporate debt restructurings took place over 1986 and 1987 and at the same time a secondary market developed in which sovereign and corporate debt sold at significant discounts from face value. While rather thin, the secondary market created a number of opportunities for debt reduction and companies with available cash took advantage of this to buy down their own debt. By mid-1988, it was estimated that Mexico’s private sector foreign debt had been reduced roughly to the $10 billion range, including a reduction of $3 billion in the first half of 1988 alone.
While a portion of Mexican private enterprise enjoys strong financial liquidity, high levels of US dollar-denominated debt have affected a broad spectrum of key industrial groups in Mexico, limiting their potential for growth and employment.
IFC identified over-indebtedness in Mexico as one of the most pressing issues for the private sector, especially in cases where restructurings were unlikely to be accomplished with the elements then available. To better understand the specific needs of the private sector and the manner in which IFC’s funds would be best employed, in mid-1986 IFC led an industry working group with experienced Mexican executives. From this experience IFC was able to put together a program, referred to internally as the Mexico Capitalization Program for the Private Sector (MEXCAP), in which IFC was to play a catalytic role in Mexican corporate restructurings.
The MEXCAP program aims to restructure a total of some $2.3 billion equivalent of debt, $2.1 billion of which is foreign debt, involving an investment of IFC funds of up to $250 million. The net reduction of debt estimated to result is up to the equivalent of $1.7 billion, including roughly $1.6 billion of foreign debt. Thus, for every US dollar of IFC’s own funds invested there will be an estimated $6 or more of net debt reduction. This high multiplier reflects IFC’s catalytic role in mobilizing capital and reaching agreement on difficult creditor/borrower issues.
IFC’s goal in corporate restructurings, as mentioned earlier, is to revitalize overindebted but otherwise viable enterprises in the major debtor countries, by reducing their level of debt and strengthening internal cash generation, borrowing capacity, and investor appeal. The appropriate capital structure, in IFC’s view, is determined by a number of factors. Important among these are the enterprise’s prospects of cash generation over time and the likelihood of achieving various levels of earnings, together with the costs of loan and equity capital.
This capital structure should not be determined, although many times it is, mainly by what creditor banks are willing to provide in the way of concessions to the troubled firm. Creditor banks make concessions according to their own considerations independently of the borrower’s needs. These factors may include the creditor banks’ accounting and regulatory framework, the valuation made by individual creditor banks of financial instruments other than conventional loans, loss provisions already made, and the banks’ exposures in different countries.
For corporate debt restructuring to be successful, pertinent facts and arguments must be credibly presented and accepted by the majority of the parties, so that the representatives of creditor banks may gain approval from their respective principals. The creditor bank steering committees that normally participate in debt restructurings are typically passive and reactive. They must be provided with alternative proposals and flexible solutions to accommodate the valid concerns and constraints of individual creditor banks.
Many of these critical elements can naturally be provided by IFC, drawing from both its special investment experience and its expertise as an international development institution. When IFC is brought into a corporate restructuring by an enterprise, its shareholders, creditor banks, or governments, it typically follows a three-phase approach.
Company appraisal and evaluation. The first phase consists of a detailed operational and financial review of the company by IFC’s industry and financial specialists, culminating in the preparation of a series of proposals to enhance operational efficiency as well as preparation of projections of cash flow, including prospects for increasing cash flow from internal measures or from favorable market developments. This exercise attempts to identify the internal resources an enterprise may command and to contribute to the restructuring solution. The firm’s cash flow prospects establish its debt-servicing capacity and, to a great extent, the potential to attract new investors. Having achieved a consensus on the firm’s long-term business strategy, noncore fixed assets are identified for divestiture along with disposable liquid assets.
Financial engineering. The second phase of IFC’s work involves attempts to determine how a firm’s internal resources might be used to yield the appropriate capital structure for the enterprise while maximizing their potential value to creditor banks. The appropriate capital structure is achieved mainly by debt reduction techniques and is central to the subsequent phase of creditor negotiations.
While there are many combinations and permutations possible, three debt reduction techniques are mainly used:
Debt buy-back: the borrower may be able, directly or indirectly, to acquire its own debt at a discount, generally below that for the firm’s debt in recent trading in the secondary market but typically above that available for sovereign debt. (For example, in countries such as Mexico, relatively small amounts of nonperforming private corporate debt may typically be traded between financial institutions and investors at discounts of 75–80 percent while sovereign debt may be traded at a discount of 45–55 percent). In this situation, a large proportion (but not all) of creditor banks can be induced to sell private corporate debts voluntarily through a sale directly negotiated with the borrower when discounts reach the 55–65 percent range—the higher price encouraging a greater number of creditors to sell their debts. IFC’s recent experience indicates that most creditor banks prefer to reduce their commercial credit exposures for nonperforming credits in major debtor countries through such debt sales.
Debt-to-equity conversion: in this context the typical debt-to-equity conversion involves a simultaneous set of transactions in which: (1) the debtor repays the entire outstanding amount on given loans, and (2) the creditors who hold the notes in question subscribe shares in the debtor company for the full amount received (on the books) and thereby convert a debt claim to an equity claim of the same amount. The debt-to-equity conversion outlined here is actually a straightforward equity subscription that can be achieved with or without the assistance of a formal government program (such as those of Chile, Mexico, and other countries).
Debt swaps and exchanges: debt may be swapped or exchanged for new notes, including quasi-equity type obligations, with modified terms, including such features as lower principal, longer repayment periods, and lower interest rates. Creditors can often retain some potential for additional cash recovery through arrangements whereby any windfall earnings made by the company trigger mandatory prepayment of loans. In recent cases where IFC was involved, exchanges have tended to be for a “strip” of securities, that is a series of loan, quasi-equity, and equity claims tailored to meet creditor concerns as separable instruments with decreasing payment priorities.
Negotiation and investment. The third and final phase of IFC involvement begins by taking the results of the company appraisal and the financial engineering as a proposed starting point for negotiations. An IFC investment of flexible new funds is generally offered (provided certain conditions are met to assure a sound credit risk) as a key contribution to the overall solution and as an incentive for quick and productive discussions. The object of the negotiations is to define a menu of options which permits flexibility and choice for individual creditor banks in a manner which balances the burden among parties and preserves the appropriate capitalization for the enterprise. Along with IFC’s investment, additional financing in the form of new loans and new risk capital is mobilized. Because the restructuring agreement may take some months to achieve, the ability to define the ultimate capitalization early in the process helps to involve new lenders and investors at the earliest stage.
IFC’s approach to corporate restructurings is market-oriented. First and foremost, its intervention is based on the discount available on debt traded in the secondary markets. Second, it brings in new investors in cases where they are likely to perceive a greater value in company equities than that perceived by original creditor banks (this is, in fact, generally the case). Third, debt and equity securities crafted for the restructurings are designed with a high degree of transferability—which translates into providing the holder with greater liquidity and more options for future asset management. Finally, the creditor banks are offered a flexible menu of options that accommodates the accounting and regulatory situations faced by individual banks and takes account of their separate perceptions of commercial and sovereign risks.
The creative use of financial mechanisms has become the hallmark of corporate restructurings. Because the specific mechanisms (i.e., claims on cash) affect the perceived valuation by individual creditors and the accounting and tax consequences for both the creditors and the company, IFC attempts to use them to bring optimal value to the creditors while leaving the underlying target capitalization of the firm unchanged. The final choice of mechanisms, and therefore the form of the restructuring solution, of course, is determined case-by-case during the negotiation process according to individual needs.
Since IFC formally incorporated restructurings as an activity in its FY 1985–89 Five Year Plan, it has participated in 48 different corporate restructurings (including restructurings of companies already within its portfolio), has provided restructuring technical assistance to another 14 companies, and has rendered informal advice and assistance to many more companies. Through June 30, 1988, IFC’s investments in these operations amounted to over $400 million of equity, loans, and quasi-equity. About one half of these operations have been in Latin America and the Caribbean, and most of the rest in Africa and Asia. Typical examples of recent corporate restructurings involving IFC in an advisory role include the restructuring of a large petrochemical project in Chile, a diversified producer of poultry, livestock, and processed meats in Brazil, the leading producer of processed meats in Mexico, a large engineering firm in the Philippines, and a diversified textiles manufacturer in Argentina.
IFC’s Initiatives in Sub-Saharan Africa
Conditions in the region pose a challenge to IFC. How IFC is helping smaller enterprises
Guy C. Antoine
Coordinator, Africa Enterprise Fund, IFC
In most of Sub-Saharan Africa, economic conditions make the task of promoting private sector growth somewhat different from that which IFC faces in other parts of the world. Much of the region is made up of small, poor economies in which the modern private sector plays a limited role. In many of these countries, human and material infrastructure has not developed far enough to sustain much growth of private companies. Small, relatively unsophisticated enterprises produce the bulk of output and account for up to 80 percent of modern-sector employment. For many years, a number of governments in the region pursued policies which tended to discourage large private investment. Important changes are now taking place in this respect, however. (See “Adjusting Industrial Policy in Sub-Saharan Africa” by William F. Steel, Finance & Development, March 1988.)
Sub-Saharan Africa presents a particular challenge to IFC. It offers comparatively few opportunities for the relatively large projects that IFC normally supports. Yet IFC also has the financial resources and the development expertise to play a unique role in fostering the growth of private initiative in smaller projects, and in assisting African entrepreneurs who have the ability and the resources to engage in modern productive ventures.
Over the last 12 years IFC has allocated a considerable share of its professional resources to African operations. It has sought to support smaller projects in Africa than it would elsewhere and it has generally accepted that its investments there would carry a greater risk of loss and more uncertain returns than those in other regions. More recently, IFC has launched a number of initiatives to supplement its regular investment activities in Africa. Two such initiatives aim to strengthen local capabilities in project preparation and in corporate management, while a third will increase IFC’s support to smaller enterprises.
IFC made its first investment in Sub-Saharan Africa in 1960. Between then and June 30, 1988, its Board of Directors approved 211 investments in 35 Sub-Saharan countries, for a total of $975 million. The projects financed over the period had a total cost of approximately $4.5 billion and resulted in the creation of 120,000 jobs. Today, about one in every four new investments made by IFC is located in Sub-Saharan Africa, and IFC’s investment portfolio in the region amounts to $464 million, or 14 percent of IFC’s worldwide portfolio. Individual investments have been extremely diverse, ranging from a $0.6 million loan to a small producer of packaging materials in Somalia to a $55 million investment for the rehabilitation of Ghana’s largest gold mine.
However, five sectors account for the bulk of IFC’s exposure in Sub-Saharan Africa, with roughly equal financial weight in the portfolio: agribusiness and food; textile manufacturing; mining (which is primarily export oriented); light manufacturing industries; and services (essentially tourism and financial institutions to which IFC provides resources as well as policy and technical assistance). In recent years, IFC has concentrated on investment activities of particular economic importance to the host countries. By supporting agroindustries, IFC has assisted member governments to reduce dependence on imported processed foodstuffs. By financing mining and resource-based export-oriented projects, it has helped member countries secure the foreign exchange critically needed to sustain their development. Its investments in the rehabilitation or modernization of existing enterprises have helped consolidate and strengthen the industrial base in a number of Sub-Saharan countries where it had been shaken by the massive economic recession of 1980–84. In particular, IFC has been active in privatizing and revitalizing previously publicly owned corporations which governments had decided to turn over to the private sector under their economic policy reform programs.
For the near future, IFC plans to double its investment portfolio in Sub-Saharan Africa by investing $450 million in approximately 100 new projects, representing a total investment of over $1.5 billion. To support this ambitious program, the departments responsible for investments in the region have been strengthened, and an additional field office was opened this year in Nigeria, a country where private sector activity is developing rapidly.
In recent years, a growing number of successful African entrepreneurs with experience in trade, commerce, or in the traditional small-scale sector have sought to make the transition into the modern sector and have sponsored new ventures or expansions of existing businesses requiring relatively substantial capital expenditures (typically, over $500,000). To assist such entrepreneurs in designing viable, well thought-out projects, IFC co-sponsors the Africa Project Development Facility (APDF), jointly with the African Development Bank (ADB) and the United Nations Development Programme (UNDP). The aim is to accelerate the development of African-sponsored productive enterprises as a means of generating self-sustained economic growth and productive employment. This Facility was established in 1986 as a UNDP technical assistance project of which IFC is the executing agent. Funding of some $17.6 million was contributed by the three sponsoring organizations and a group of 14 donor countries (Belgium, Canada, Denmark, Finland, France, Federal Republic of Germany, Italy, Japan, the Netherlands, Norway, Sweden, Switzerland, United Kingdom, and the United States). The Governments of Brazil, India, and Israel have also indicated their willingness to support APDF by providing it with experts.
APDF does not itself provide project financing but helps entrepreneurs formulate and screen project ideas, prepare feasibility studies, select appropriate project partners, and secure equity and loan financing from banks, development institutions, and other sources of capital. Where necessary, APDF helps its clients obtain appropriate technology as well as the managerial assistance needed to start up and operate projects. It also helps foreign investors or financial institutions seeking to identify local partners in Sub-Saharan Africa, by bringing parties together and helping negotiate fair and equitable terms of cooperation.
APDF operates out of two regional offices located in Abidjan and Nairobi. The demand for its services has been brisk: 976 requests for assistance, emanating from about 30 countries, have been received since November 1986. Most of the proposals submitted to APDF have been for projects based on domestic resources; most were either export-oriented or geared to the basic needs of local consumers. About one half of the projects were for the cultivation or primary processing of a wide range of agricultural and food products. Manufacturing ventures in fields such as textiles, metal working, construction materials, and wood products accounted for another 30 percent. By the end of August 1988, APDF had brought 22 projects to successful completion, and another 110 projects were at various stages of development. The average size of the 22 completed APDF projects was around $1.4 million, with an employment creation in the region of 80 to 100 jobs per company.
The demand for APDF’s services has highlighted the existence in Sub-Saharan Africa of a vibrant private sector, eager to capitalize on market opportunities and poised to respond to government reforms aiming to establish a freer regulatory environment.
IFC is also sponsoring the establishment of the African Management Services Company (AMSCo), which will be incorporated with an initial share capital of no less than $7 million. When it becomes operational in 1989, AMSCo will provide a package of technical and managerial services to African enterprises wishing to improve their operating efficiency.
The basic premise for AMSCo is that, to be competitive and remain viable over the long term, African businesses need to be efficiently run. Africa’s severe shortages of people trained and experienced in managing relatively complex ventures has contributed to the disappointing performance of enterprises in the region. Through management contracts, AMSCo will provide skilled and experienced managers to help African enterprises improve their operations. These managers will be given line authority and will be responsible for installing management systems, improving operating and financial performance and, where necessary, assisting clients in arranging the technical rehabilitation of their enterprises. They will also train and develop qualified senior managers “on the job” to succeed them at each client company. AMSCo’s goal will be to leave behind locally managed businesses that are profitable, self-sufficient, and well integrated into the business community.
The AMSCo project has begun to mobilize resources from the international public and private sectors. Besides IFC, the African Development Bank and institutions from Denmark, Finland, France, the Netherlands, Sweden, and the United Kingdom have already confirmed their participation. Up to 50 private companies active in Sub-Saharan Africa are also expected to become shareholders in AMSCo and extend support to its operations.
AMSCo will provide its services on broadly commercial terms and become financially self-sustaining over the medium term. However, to launch the project and to make its services available to African companies that are currently without alternative sources of financing, two independent special funds will be established: the Management Development Fund will provide grants to those client enterprises unable to meet the expenses of training local successor-managers, while the Management Loan Fund will provide mediumterm loans to some clients to finance the initial cost of AMSCo’s services. These funds will be endowed with grant resources totaling some $14 million. Committed donors at this stage already include UNDP, ADB, and nine countries: Belgium, Finland, Germany, Italy, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.
Most African countries that are members of IFC have undertaken to strengthen the role of the private sector in their economies and are taking steps to foster conditions in which entrepreneurs can invest and produce efficiently. They are, in particular, encouraging the growth of relatively small, modern enterprises relying largely on domestic resources and simple technologies, which are responsive to the consumption needs of Africa’s markets and are an excellent training ground for fledging enterpreneurs. Such enterprises are capable of making a significant contribution to the host economies. Their advantages are likely to become more marked as the regulatory procedures applying to private enterprises are streamlined and policy distortions eliminated.
Though the policy environment has been improving, the development of smaller, mainly locally sponsored enterprises remains constrained by a number of factors, including a chronic scarcity of risk capital and long-term loan resources. The problem is particularly severe for risk capital because of the rudimentary state of African capital markets and near-absence of institutions capable of mobilizing this type of resource. Consequently, risk capital must come primarily from personal or family savings, which are often inadequate. The availability of term loans has varied somewhat from country to country and has depended largely upon government priorities in credit allocation. However, loan financing on a project basis (that is, without outside guarantees or recourse against nonproject assets) has generally been in short supply, as most lenders have shown a marked preference for short- and medium-term lending against collateral and only a limited appetite for long-term project risks.
To address the problems outlined above, and support the renewed efforts of its African member countries in favor of smaller enterprises, IFC’s Board of Directors recently authorized the establishment of the Africa Enterprise Fund (AEF). This will function within IFC for a three-year experimental period during which it will seek to invest up to $60 million in approximately 100 enterprises. AEF will operate under IFC’s general investment policies and help entrepreneurs establish new businesses as well as rehabilitate or expand existing enterprises. Its investments will take the form of loans, guarantees, and equity-type instruments, and will be made generally on commercial terms. The projects receiving its support will have to meet the basic tests associated with IFC’s role; that is, they should earn a satisfactory financial return and also benefit the economy of the host country.
Investments by AEF will be in amounts ranging from $100,000 to $750,000, in projects whose total costs will be between $250 thousand and $5 million. AEF will finance up to 40 percent of project cost. Further, by delegating some decision-making functions to IFC’s regional offices, and by working with local financial institutions, AEF will be made responsive to the needs of its intended clients. IFC’s offices in Côte d’Ivoire, Kenya, and Nigeria will administer AEF.
Partner financial institutions having strong local presence will co-invest with AEF and participate in investment appraisal and supervision. The Africa Enterprise Fund is projected to become operational early in 1989. It will be coordinated with IFC’s other initiatives in Africa.
The IFC At a Glance
The International Finance Corporation was created in 1956, as an affiliate of the World Bank, to promote development by supporting private enterprise directly. Unique among multilateral development institutions, it makes unguaranteed loans and equity investments, in private and mixed companies in its 112 developing member countries. As a partner with other investors, sharing their risks, IFC is able to encourage other private investors to participate in ventures they might otherwise see as too risky. IFC can use its experience to help design a sound financial structure for companies in which it invests, and to bring in other partners to fill any gaps that might exist in technology, management, marketing, or other aspects of the business.
IFC’s original function, and still its major activity, is project finance. It has become the largest source of multilateral financing for private investment in developing countries; its own investments total nearly $11 billion, assisting over 1,000 ventures in more than 90 countries. Last year IFC’s Board approved a record 95 investments in 40 countries (see charts). The total cost of facilities being financed with IFC assistance is over $5 billion; IFC itself will invest just over $1 billion and plans to syndicate an additional $231 million to other financial institutions.
Created to promote development, IFC will not invest unless the activity will benefit the host economy. Since it depends on the company’s cash flow for the return on its investment, IFC must also insist on financial soundness. In every one of its 32 years of operation, IFC has managed to achieve both these goals—investing only in economically beneficial projects, often in difficult circumstances, and making a profit.
IFC’s contribution cannot be measured only by the dollar volume of its investments. A growing array of services has been developed, some of which are offered to individual private businesses and others to governments (see chart 4). The Capital Markets Department of IFC is responsible for the oldest and largest of such efforts, advising government regulatory agencies and stock exchanges on laws and institutions to promote healthy financial and securities markets. It helps to create, and often invests in, local financial institutions. Its Emerging Markets Data Base covers 19 developing country stock markets and over 400 stocks listed in them.
Chart 1The evolution of IFC lending Chart 2Number of projects Chart 3Net Income Chart 4Current committed portfolio by sector
Recognizing other needs, IFC continues to add new services. In 1986 it established the Africa Project Development Facility, to help local entrepreneurs develop sound projects and find financing for them. The Foreign Investment Advisory Service, also established in 1986, has assisted over a dozen developing country governments to create policies, laws, and institutions to better attract and regulate foreign direct investment The Africa Enterprise Fund was created in July 1988 to identify and finance small and medium-scale companies in Sub-Saharan Africa. To meet the needs created by the financial turmoil of the 1980s, IFC’s investment staff devote an increasing amount of time to restructuring companies that are in financial distress but otherwise sound. This activity which, like many other IFC services, is based on fees paid by the clients, is available to companies whether or not IFC has an investment in them already.