March 1990 COMMODITY FUTURES NVjrch 11, Covered Call Options: A Proposal to Ease LDC Debt Steven P. Feinstein and Peter A. Abken The large debt burden carried by many developing nations not only has hampered these countries' economic development but has also threatened their commercial bank lenders. Economic austerity measures aimed at CATTLtiEp»£R. (Liuti HtoM* ) p., lb reducing this debt have severely limited the funds less ca«5 SirtWr P„li Mir < Apr <• MavìUv-t-. Vi' p A frf Mav ? developed countries have available for domestic invest- »VI 0.00 on o v 0 do o 70 ment, further retarding their economic growth. The authors' proposal—that LDCs sell long-term, high strike price call options on their chief export commodities—would Aft J«P v,î allow LDCs to generate revenue without renegotiating existing debts or giving up ownership of productive resources. any less developed countries (LDCs) of debt relief is not a physical commodity but struggling to pay off massive loans rather a type of financial asset—namely long- Mpossess an untapped, exportable term, high strike price call options on their chief resource for which a demand exists in devel- export commodities. oped nations. Revenue from such a resource The proposal in this article offers interested would not only help to service debts but also parties such as commodity users or speculators further the indebted developing countries' the opportunity to bid on the right to purchase a economic advancement. This potential source certain quantity of a chief export commodity for 2 ECONOMIC REVIEW, MARCH/APRIL 1990 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis March 1990 a prespecified price on a given future date. In making these call options available, LDCs would The World Debt Problem—A Review in effect be sel ling commodity price insurance- insurance that pays off if the commodity price Since 1982 the high indebtedness of many rises beyond some high level. For example, a developing nations has placed a severe strain bidder might purchase the right (but not the on both the LDCs and the world banking com- obi igation) to buy Mexican oil at $27 a barrel on a munity. According to the most recent account- given date five years hence, even though the ing, LDCs owe $1.3 trillion to foreign banks, price of oil at the time of bidding is only $ 17.25. governments, and international agencies.3 Not Should the prevailing market price remain be- only have LDCs struggled to service this debt, low the "strike" level of $27, the option owner but exposure to these troubled loans has would simply elect not to carry out the transac- threatened the strength of commercial banks. tion.1 Should oil rise to $30 a barrel by the The roots of the problem can be traced to the agreed-upon expiration date, though, the bid- volatility of commodity prices and interest rates der could purchase the oil at $3 below prevail- over the last two decades. The oil price increases ing prices. Although the LDC must then re- of 1973 and 1979 led to a massive redistribution linquish goods for less than the going rate, of wealth from oil importers to oil exporters, revenue from the earlier option sales would primarily those in the Middle East. These "pet- have ameliorated matters during a period of low rodollars" accumulated in commercial banks prices. The loss of potential profits would come around the world as surplus funds awaiting in- at a time of high prices when the selling country vestment opportunities. Because of their ap- could best afford it. parent excellent potential to develop rapidly, Using call options in meeting debt obliga- Latin American economies were deemed to be tions is not an entirely new idea. Numerous excellent credit risks. As a result, these coun- articles in academic journals have suggested tries received enormous loans from commer- construction of financial instruments that tie a cial banks. borrower's liabilities to a commodity price, and The loans were predominantly short-term, the recent Mexican loan restructuring (described with interest rates tied to the London Interbank below) includes such a feature.2 In other plans, Offer Rate (LIBOR).4 By 1980 three-fourths of the however, options have been bundled together debt owed by Latin American countries was set with bonds. By selling options separately, as at variable rates; 40 percent was due for repay- proposed here for the first time, an LDC can ment within one year, and 70 percent within generate substantial revenue without renegoti- three years.5 From 1971 to 1980, LIBOR was on ating all its outstanding debts. average 0.8 percent (80 basis points) less than Such an "unbundled" approach is possible the rate of U.S. wholesale price inflation; de- with this proposal because it calls for selecting a veloping countries were effectively borrowing at strike price high enough to ensure that the very low or even negative real interest rates.6 debtor will face the future obligation only when Later, however, rates on LDC debt surged as the fulfillment of all other obligations is relatively United States tightened monetary policy in an easy. This feature would obviate the need to attempt to control inflation. LIBOR averaged 9.2 gain the endorsement of existing creditors prior percent (920 basis points) above the U.S. infla- to selling the options. Keeping the options tion rate from 1981 to 1982.7 As rates rose, debt separate from debt instruments also affords the service obligations soared. LDC greater flexibility in the management of its The worldwide recession that accompanied revenue flow and debt. A program of selling higher interest rates further hurt LDCs. Reduced options when commodity prices are low and redeeming them when prices are high can help an LDC smooth revenue across periods of high The authors are economists in the financial section of the and low commodity prices. A further advantage Atlanta Fed's research department. They would like to thank Marco Espinosa, Larry Wall, and Robert Kahn for helpful is that the market for the unbundled option is comments. They gratefully acknowledge research assis- likely to be wider than the market for options tance provided by Karen Hunter and Hermawan Djohari. coupled with debt. The authors accept sole responsibility for any errors. I 7 FEDERAL RESERVE BANK OF ATLANTA Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis March 1990 demand for their exports and plummeting com- debt. Mexico received concessions on principal modity prices compounded their misfortune. As and interest, along with new loans (Peter Tru- the value of imports began to overwhelm that of ell 1990). exports, current account payment balances of The LDC debt problem, however, is far from the highly indebted countries turned sharply over. No single approach is likely to work across negative.8 By the end of 1982, 34 developing the board, and in mosteases debt reduction will countries were unable to service their debt probably be part of future financial arrange- fully.9 As oil exporters, Mexico and Venezuela ments. Yet developing countries that rely solely were special cases. As oil prices leveled off and on debt reduction may find it difficult to borrow then began to drop, however, these two coun- in the future. Nor is rescheduling old loans and tries also began to have difficulty making pay- securing new loans a satisfactory long-term so- ments on the substantial debt they had ac- lution. Many experts now agree that the prob- cumulated against future oil revenues. lem is one of solvency rather than a lack of The predicament has taken a heavy toll on the liquidity available to the LDCs (Anna J. Schwartz LDCs. In net terms Latin America and the Carib- 1989). In other words, these nations' economic bean exported capital in each of the last eight prospects are sufficiently bleak that markets years; the 1989 net outflow amounted to $24.6 doubt LDCs can make good on their past financial billion (see Barbara Durr 1989). As a result, obligations. Consequently, as long as stretching domestic investment and development have payments out over longer horizons preserves suffered. Growth over the last decade has slowed the net present value of LDCs' liabilities, such a to a crawl, making repayment of the foreign debt tactic will not end the crisis. even more difficult and less likely.10 Moreover, Highly indebted countries must therefore standards of living have declined. Between 1980 search for ways to restore their solvency. Essen- and 1987, per capita consumption in the LDCs tially, in order to pay off their huge debts, they fell nearly 12 percent (see Giancarlo Perasso must raise more revenue. Better economic plan- 1989, 535). If the quality of life for the citizens of ning and measures to stem domestic capital LDCs is to improve, many believe, capital must flight are the sorts of actions that will have last- flow into these countries on net, not in the ing positive effects (A. Schwartz 1989 and Ru- opposite direction. diger Dornbusch 1987). Some policymakers and Lenders have also suffered. In 1982 the sum of analysts advocate debt-equity swaps as means LDC loans on the books of U.S. banks was over by which LDCs can pay off loans without incur- 180 percent of the capital in those banks (Jeffrey ring new liabilities; however, these transactions Sachs 1989a). Since then, the market value of represent permanent sales of an LDC's produc- LDC loans has fallen sharply below book value. tive resources (such as forests, mines, and fac- For example, by March 1990, Peruvian loans tories) and so cannot provide revenue on a could be sold for only six cents on the dollar, continuing basis.