COUNTRY RISK ASSESSMENT
External Debt Crisis Investment & Opportunities -IIApril 2008
MH BOUCHET/CERAM (c)
Various approaches to country risk assessment
analysis Quantitative approach : rating and scoring Econometric approach and modelization Analytical approach: crisis typology (Indosuez) Principal Component Analysis (CDC) Logit Analysis Non-linear conditional analysis (threshold levels & breaking points) External debt analysis
MH BOUCHET/CERAM (c)
Qualitative
US banks cut lending to EMCs... while improving capital ratios!
400 US$ billion 350 300 250 200 150 100 50 0
81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
3
Tier 1 capital
US Banks‟ loans to EMCs
BAKER PLAN BRADY PLAN
05
19
19
19
19
19
19
19
19
19
19
19
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19
19
19
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20
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07
US Banks cross-border claims on EMCs end-2007
Total US banks’ claims= US$189 billion O/w on India = US$28319 million O/w US foreign office claims on India= US$25162 O/w claims on India‟s banking sector= US$10097 O:W claims on India‟s public sector= US$6785 O/w Citibank’s claims on India= US$17470 million O/w <1 year= 82% (>1% of total assets or >20% of capital)
Source: USFFIEC
MH BOUCHET/CERAM (c)
The Brady Plan = Menu-based debt restructuring workouts
MH BOUCHET/CERAM (c)
The 1989-2000 Brady Debt Reduction Plan
1. 2.
1.
2.
3.
Debtor countries: Tough macroeconomic adjustment programs under the monitoring of the IMF/WB (SALs) Cofinance LT debt repayment guarantees with purchase of zero-coupon bonds London Club banks: Provide deep discounts through interest or debt stock reduction Get accounting and regulatory incentives Shift to specific purpose financing and voluntary lending (2003-2007)
MH BOUCHET/CERAM (c)
The Brady Plan
Objective: defaulted sovereign London Club bank
loans would be exchanged for collateralized, easily tradeable 30-year bonds, with bullet repayment London Club banks would grant some amount of debt relief to debtor nations, in some proportion of secondary market discounts. The new Brady bonds would be guaranteed by zerocoupon US Treasury bonds which the defaulting nation would purchase with financing support from the IMF/World Bank.
MH BOUCHET/CERAM (c)
Brady Bonds
Brady Bonds are named after former U.S. Treasury Secretary Nicholas Brady. Brady bonds have their principal guaranteed as well as x semi-annual interest payments, whose guarantee is rolled over. Bullet repayment is collateralized by 30-year zero coupon bonds, with a specific-purpose issue of the US Treasury, the Banque de France or the BIS. Cross-default clause
MH BOUCHET/CERAM (c)
The Brady plan in action
Debt cancellation backed up by commercial banks‟ reserves for loan-losses with regulatory incentives 35%
65%
SENIOR DEBT New debt with long-term maturity, principal collateralization, rolling interest guarantee, and cross-default clause
MH BOUCHET/CERAM (c)
Brady Bonds
Default on interest payments would trigger exercise of interest guarantee and of principal collateral guarantee Bullet Payment at maturity
Prime rate or LIBOR + Spread of 13/16
ZCB
t0 t10 t20
MH BOUCHET/CERAM (c)
t30
How to assess and calculate the market value of a collateralized Brady Bond?
Brady
bonds comprise defaulted London Club debt, repackaged and backed by 30-year US Treasury bonds as collateral, often including a rolling 18-month interest guarantee.
1. Strip the bond by separating the risk from the no-risk elements (interest and principal): risk-free discount rate 2. Calculate the risk-adjusted NPV of the guaranteed and non-guaranteed streams of interest payments and the principal payment at maturity
MH BOUCHET/CERAM (c)
Brady Bonds
February 1990, Mexico became the first country to issue Bradys, converting $48.1 billion of its eligible foreign debt to commercial banks. US$200 bn of Bradys from 18 countries in Asia, Africa, Eastern Europe and Latin America Mexico, Brazil, Venezuela & Argentina accounteed for more than 2/3 of Brady Bonds issued.
In
MH BOUCHET/CERAM (c)
Market-driven menu of options:
new money loans + discounted buybacks
+ exit bonds + debt conversion + debt restructuring bonds
Official Support: up to US$ 25 billion to
support the Brady initiative from the IMF + World Bank + RDB + OECD creditors:
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Financial components of a Menu:
I. Buying back debt at a discount, either formally or informally, enables
developing countries to reduce debt by exploiting the discount on commercial bank loans in the secondary market.
The effectiveness of a buyback depends on how it is financed whether it be by a loan or donation and on its impact on the future debt servicing profile. For highly indebted countries, one aim of buying back debt is to enable small banks to exit before a restructuring plan. For low income countries with little debt, the purchase can be used to eliminate commercial bank debt in its entirety. However, the purchase of debt raises legal and legislative issues. Restructuring agreements require the legal waiver of restrictive clauses prohibiting buybacks or conversions.
MH BOUCHET/CERAM (c)
Financial components of a Menu:
II. Debt Exchange consists of converting old claims for more favorable instruments both for the creditor and the debtor country: Brady bonds (discount bonds, par bonds, and FLIRBs) Debt/Equity conversion Debt restructuring with new coupon and longer term maturity (Pakistan, Russia, Ukraine in mid-1999)
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Types of Brady Bond Instruments
Par Bonds Maturity: Registered 30 year bullet issued at par
Rolling interest guarantees from 12 to 18 months Principal is collaterallized by U.S. Treasury zero-coupon bonds
Coupon: Fixed rate semi-annual below market coupon Guarantee:
Discount Bonds (DB) Maturity: Registered 30 year bullet
amortization issued at discount Coupon: Floating rate semiannual LIBOR Guarantee: Rolling interest guarantees from 12 to 18 months.
Front Loaded Interest Reduction Bonds (FLIRB)
Maturity: Bearer 15 to 20 year semi-annual bond. Bond has
amortization feature in which a set proportion of bonds are redeemed semi-annually. Coupon: LIBOR market rate until maturity. Guarantee: Rolling interest guarantees generally of 12 months available only the first 5 or 6 years.
MH BOUCHET/CERAM (c)
Brady Bonds
Debt Conversion Bonds (DCB) Maturity: Bearer bonds
maturing between 15-20 years. Bonds issued at par. Coupon: Amortizing semi-annual LIBOR market rate. Guarantee: No collateral is provided
New Money Bonds (NMB) Maturity: Bearer bonds
maturing 15-20 years. Coupon: Amortizing semi-annual LIBOR. No collateral
Past Due Interest (PDI) Maturity: Bearer bonds maturing
10-20 years. Coupon: Amortizing semi-annual LIBOR. No collateral
Capitalization Bonds (C-Bonds) Issued in 1994 by Brazil
in the Brady plan. Maturity: Registered 20 year amortizing bonds initially offered at par. Coupon: Fixed below market coupon rate stepping up to 8% during the first 6 years and holding until maturity. Both capitalized interest and principal payments are made after a 10 year grace period.
MH BOUCHET/CERAM (c)
Par, Discount and FLIRB bonds:
1.
may have principal collateralization, usually 30 year U.S. Treasury zero-coupon bonds, and/or rolling interest collateralization (usually 1218 months); may be excluded from further new money requests of the bond issuer in order to maintain the implicit seniority of the new debt; may be eligible for debt-equity conversions in the developing country. bonds with recapture clause (Argentina, Nigeria, RCI…): In some cases, the bonds carry rights to receive additional payments that are triggered by an increase in the price of the country's major exportable goods. The value recovery clause can be linked to the evolution of GDP, an index of terms of trade, or export receipts.
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2. 3. 4.
Bank Options in Debt Restructuring Menus BANKS Par Bonds Canada 48% France 79% Germany 80% Japan 18% United Kingdom 48% United States 58% MEXICO PHILIPPINES Discount Bonds New Money Buybacks New Money 52% 0% 100% 0% 9% 12% 4% 96% 20% 0% 81% 19% 81% 0% 41% 59% 45% 6% 54% 46% 24% 19% 18% 82%
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The market-based menu of debt restructuring instruments
Bank Menu Choices in Brady Agreements Par Bonds 66 19 32 Discount Bonds 34 35 35 60 65 58 Buybacks 46 13 63 35
Argentina Bolivia Brazil Bulgaria Costa Rica Dom. Republic Ecuador
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Brady Bonds
Arg Par Arg FRB Arg '27 Brz C Brz '27 Bul IAB Mex Par Pol Par Rus '28 Ven DCB Vie Par
48.000 41.000 31.000 75.250 72.750 85.000 93.000 75.250 107.750 78.250 44.000
50.000 42.000 33.000 75.437 73.000 85.500 93.250 76.250 108.000 78.750 45.000
MH BOUCHET/CERAM (c)
Market-based menu approach: the importance of the tax, accounting and regulatory framework
In June of 1999, the BIS launched a revision of the capital adequacy guidelines, known as the 1988 Cooke ratio. The BIS‟ 12 banking comptrollers were to edict new regulations to be applied by 2002, in consultation with the EU‟s commission. The Cooke solvency ratio imposes an 8% proportion between risk-weighted assets and capital. There are four risk categories, between 0 (OECD countries, IFIs) and 100% (EMCs risk). In 1995, the BIS adopted a reformed Capital Adequacy ratio to account for investment and transaction financial instruments. The ratio also distinguishes between market risk and counterpart risks.
MH BOUCHET/CERAM (c)
Market-based menu approach: the importance of the tax, accounting and regulatory framework
The Capital Adequacy ratio stipulates that various exposures to risk must be considered, including interest, counterpart, volatility, currency risks…) and that capital requirements must be assessed by Value at Risk methods. Capital comprises two categories: 1. Tier 1: capital, reserves, benefits, and “FRBG” 2. Tier 2: reevaluation reserves, guarantees, public subsidies, subordinated debts under specific conditions. The 2000 BIS reform aimed at adjusting the risk weighted assets to take into account (i) not the legal nature of risk but rather the underlying risk quality, (ii) risk mitigating tools (guarantees, collaterals) and (iii) risk ratings.
MH BOUCHET/CERAM (c)
International banks‟ reserves against LDCs claims in the mid-1990s
OCDE COUNTRY FRANCE BELGIUM CANADA GERMANY JAPAN NETHERLAND SWITZERLAND UNITED-KINGDOM UNITED6STATES
RESERVE LEVELS 58% 60% mini 35% mini 70% 30% 45% 70% 65% 58% money-center
TAX REDUCTION Yes Maxi 60% No Yes Maxi 45% Yes 1% only Yes Yes Yes 50% No
CAPITALISATION Yes No No No 29% No No No Yes
NUMBER OF COUNTRIES 42 50 43 AD-HOC 38
90 Matrix AD-HOC
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Basles II regulatory guidelines
Came
in operation in 2007: the new guidelines force banks to allocate more capital against loans to countries (and companies) that are lower –rated or not rated at all.
In addition to credit and market risk, the operational risk capital charge rests on a basic indicator approach, a standardised approach and an advanced risk-sensitive measurement approach. This risk stems from inadequate or failed internal processes.
MH BOUCHET/CERAM (c)
Basles 2= Tax, accounting and regulatory framework
Impact of new capital adequacy guidelines on EMCs „ capital market access? Negative impact on OECD countries with ratings < AA- = higher capital requirements (Mexico, Turkey, Korea…) = 100% Non OECD countries with ratings < B- = 150% capital backing Non OECD countries with ratings > BB+ = lower capital backing = from 100% to 50% or even 20% and 0% (Taiwan and Singapore) Growing risk of procyclicality of banks‟ internal risk rating systems
MH BOUCHET/CERAM (c)
Tax, accounting and regulatory framework
Ratings
AAAA BBB reduced pressure on its budget
MH BOUCHET/CERAM (c)
Trading of Official Bilateral Debt During
1990, the Paris Club agreed on the principle of reducing debt through clauses stipulating the conversion of part of the obligations into local currency. The Paris Club does not set a limit for conversions applied to development aid. However, a limit of 10% is applied to officially guaranteed commercial loans (for example those covered by COFACE, ECGD and Hermes).
Conversion is a voluntary option and should be ratified by each creditor government in Paris Club bilateral agreements.
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The French Treasury started auctioning developing
countries' debts with US$20 millions of claims on the Philippines in September of 1992.
The sales' objective is to fund viable and productive local projects in the tourism, infrastructure and industry sectors, with either French, foreign or local private investors. A few large debtor countries are excluded from the list: Russia, Mexico, Brazil, Argentina and Venezuela. The Treasury followed with Tanzania in November of 1992, and with Honduras during the first quarter of 1993.
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The debt conversion operation for Tanzania was to be implemented by November 30, 1992. It involved FF 120 million of French government's claims. The offer has reportedly not met with much investor interest. Accordingly, the Treasury contemplates offering claims in a less formal framework thereby negotiating discrete sales on a caseby-case basis. In the case of Honduras, conversion involved about FF 55 million of claims by way of bids to COFACE with minimum offers of FF 5 million.
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In March of 1993, COFACE started auctioning about FF 550 million of
claims on Egypt through the Treasury. Successful bidders were Egyptian investors reportedly.
In November of 1993, the French Treasury and COFACE announced a further offer of FF1 billion of claims on Egypt. In April of 1994, COFACE auctioned off FF1.5 billion of export credits. In September of 1994, France’s Credit National auctioned FF1.5 billion of official development debt. Such claims were consolidated in the agreement dated September 12, 1991. The banks acted on behalf of local investors for pre-authorized projects Potential investors were to be represented by a banking intermediary and must have obtained an investment permit from Egypt's authorities. Successful bidders paid about 47.2% of face value with the Paris-based bank UBAF purchasing nearly FF700 millions of Egyptian claims reportedly. CCF and BNP purchased the remaining claims.
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In
September 1992, the United Kingdom export credit agency (ECGD) announced a fairly ambitious program of selling Paris Club debt. In a period of around six months, the ECGD was very successful with such sales, selling around £100 million (face value) of debt. The debts concerned are those which have been rescheduled under certain Paris Club and related bilateral agreements. Although quoted in US dollars, both sterling and US dollar denominated debts are available in almost all cases. The ECGD will only sell debt if the price it will receive implies a higher level of income than the net present value of the expected recovery of the debt, within the framework of the Paris Club agreement and given the projections of the country studies department of the ECGD.
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The demand for ECGD paper has come from banks (who wish to act as an intermediary), and increasingly from end-users. The latter option reportedly allows for greater speed and a somewhat higher prices for the ECGD. In January of 1993, ECGD auctioned off £48 million of Egyptian Paris Club debt. The proposal did not include capitalized moratorium interest, which remains as debt within the bilateral arrangements.
In March of 2000, the French government and Morocco signed an agreement of debt conversion. In July of 2000, Algeria and the Algerian government signed a debt swap scheme for the equivalent of some FF400 million. Algeria will have to set up a regulatory framework to implement the transactions within an adequate macroeconomic and legal framework.
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Part III Debt Conversion Transactions
Debt conversion constitutes the transformation of the legal and financial nature of a country's liability from a hard currency debt into some form of a domestic currency obligation. In other words, a debt conversion is a prepayment of debt at a discount in local currency. The vehicle for such debt conversions is often the secondary market of commercial bank claims where bank and nonbank creditors can sell or swap their LDC assets, investors can obtain bank loans at a discount for subsequent conversion into domestic currency assets, and debtor countries can repurchase their own discounted debt. Altogether, cumulative debt conversion volumes have reached about US$45 billion, with an annual peak of US$10 billion in 1990, owing to large-scale debt-equity conversion programs in Argentina and Chile.
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Debt Conversion: a positive sum game?
Face value= $1000
DISCO UNT O N DEBT = 80% 800
Price of Debt
Debt Redemption P rice
Debt Face Value 1000
$
0
200
400
200 Incentive to Claim Holder
200 Incentive to Investor
600 Debtor Country's Share of Discount
MH BOUCHET/CERAM (c)
Positive Sum Game!
Debtor: debt cancellation with local currency payments while stimulating foreign direct investment and enhancing the role of private sector activity in the local economy (privatization) Creditor: cleaning up of portfolio with upfront cash payment while accounting losses get absorbed by loan-loss reserves Investor: access to local currency at a discounted exchange rate that boils down to an investment subsidy, thereby mitigating the overall country risk and the specific project risk
MH BOUCHET/CERAM (c)
Corporate debt swap transactions
04/2001:
South Korea‟s largest builder HEC (Hyundai Engineering & Constr.) makes a debt swap with its creditors to reduce debt ratios from 1240 % to 250%, by issuing new shares and bonds to creditors as a part of the rescue package after Hyundai reported losses >US$2.2 billion that wiped out its equity capital!
MH BOUCHET/CERAM (c)
Debt Conversion Mechanism
Funds/Grants
SECONDARY M ARKET OR AUCTIONS
$
Investor
CREDITOR BANK or BILATERAL GOVERNMENT
$
Discounted Claims
CLAIMS
LOCAL CURRENCY BONDS or ASSETS
CENTRAL BANK
MH BOUCHET/CERAM (c)
Debt-Equity Swaps
* Shares in privatized companies (Argentina, Chile, Côte d'Ivoire...) * Shares in private sector entities (Philippines, Tanzania, Madagascar, Egypt, Chile...)
Debt for Nature Swaps TYPES of DEBT CONVERSION
(Costa Rica, Bolivia, Madagascar, Ecuador, Philippines...)
Debt for Export Swaps
(Peru, Vietnam...)
Debt for LT Bond Swaps
(Costa Rica, Guatemala...)
Debt for Development Swaps
(Sénégal, Mexico, Madagascar...)
Debt for Local Currency Swaps
(Tanzania, Madagascar...)
Source: OSF
MH BOUCHET/CERAM (c)
EXCHANGE OF DEBT CANCELLATION
There are various forms of local currency payouts in debt conversion transactions: i) local currency for local cost component of investment or operating costs (salaries) ii) transfer of ownership of equity in a public company (privatization programs) iii) local currency and/or financial instruments to fund humanitarian or environmental projects iv) non-traditional exports or other domestic assets v) tax vouchers, customs duties, oil exploration bonuses... vi) monetary stabilization bonds
Michel Henry BOUCHET; Professeur CERAM
Enabling legislation: What are the various parameters of a conversion regulatory program ?
A key prerequisite in debt conversion and buyback transactions is the formulation of enabling legislation so as to waive various legal clauses which prohibit a debtor country from inequitable treatment of its debt obligations. In addition, restrictions on permissible assignees must be waived if creditor banks are to be able to sell debt to private investors. In particular, mandatory prepayment and "sharing" clauses in loan and refinancing agreements must be waived in order to open the door to debt conversion transactions. A second prerequisite is the formulation of a regulatory framework in the debtor country. One can distinguish a number of critical variables of a debt conversion program:
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1.
Amount and Pace of Conversion: the Central Bank must monitor debt conversion owing to its potential impact on monetary and budget policy. The domestic monetary implications result from the release of local currency at the time external debt is redeemed. This may create inflationary pressure, hence an impact on the IMF's performance criteria. When the monetary effect is mitigated by the issue of local-currency bonds, the creation of additional domestic debt affects credit and budget policy. Sound macroeconomic policy is thus a prerequisite for any lasting debt conversion program.
2.
Exchange rate (official or market rate) applicable for debt conversion. The exchange rate determined for the conversion has a direct impact on the actual discount that is obtained by the investor. The gap between the official and parallel market rates could be so large that it wipes out the discount the investor obtained in the secondary market transaction, thereby eliminating the implicit "subsidy" inherent in the conversion.
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3.
The eligibility criteria applicable to the type of debt: The Central Bank has the following range of choices regarding the origin of the debtor's or guarantor's liabilities to be used for conversion:
i) public sector external debt ii) external debt of national government iii) external debt guaranteed by a public sector entity iv) private sector external debt with or without a public sector guarantee v) original claims or secondary market debt
4. Legal nature of debt: Short term/Long-term, promissory
notes, trade and suppliers credits, bank loans, official bilateral debt...
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5. Quotas or ceiling on the annual (or quarterly) amount of debt to be
swapped. The quota is to be determined in close relation the macroeconomic policy objectives. Annual ceilings have been implemented in Tanzania, Argentina, Chile, Ecuador, the Philippines, and Mexico.
6.
Redemption rate: Debt conversion boils down to discounted repurchase. The redemption fee represents a "second" internal discount. It helps the central bank "capturing" a portion of the discount, thereby sharing with the investor the benefit of the transaction. Indeed, by purchasing the debt directly in the market, the country could take the full market discount for itself instead of the redemption fee only, and in the process avoid problems of creating a preferential exchange rate. In an auction based situation, the redemption rate is determined by a market-based system: potential investors bid by offering competitive discounts from the face value of the debt. The relationship between the discount rate and the redemption rate gives rise to the investor's pay-out ratio.
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7.
Fees taken by the local authorities and/or by the local intermediaries for the right to participate in a conversion.
The issue of transparency (the disclosure of complete information) is important from the investor's standpoint, since the regulatory framework is officially defined and applicable to all investors. Specified parties eligible for use of the debt conversion mechanisms: for instance, allowing the local nationals/residents to take part in the program (allowing residents to bid for local currency can be a way of encouraging capital flight repatriation).
8. Degree of transparency in the program:
9.
10. Procedure to be employed in assigning the right to convert debt:
the procedure can be quarterly ceilings of local currency, regular auctions of local-currency assets, case-by-case allocation with regard to sectoral priorities...
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11. The form of the conversion proceeds: Very few
programs provide for an upfront cash, due to monetary implications. In most cases LDC governments create some sort of deposit account or alternative local currency denominated term debt. The Central Bank might also provide protection to the investors against inflation and/or currency depreciation. If conversion leads to the issue of local-currency assets, two ways are possible: the investor can gradually redeem the "stabilization bonds" in local currency for investing the proceeds, or the investor has only access to the interest payment flow on the bond. This latter case is often use for NGOs involved in debt-for-nature swap.
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12.
Eligibility of local currency investment (or Additionality): Debt equity conversion could be used as a vehicle for mobilizing new foreign investment in priority sectors of the economy and for stimulating privatization. The program could also be designed (with appropriate restrictions on the sector eligibility) to promote export generation and import substitution. One of the objectives of the government is to prevent "round tripping", that is, access to local currency through the use of discounted bank claims without investing at home the local currency proceeds.
13. Requirement of "matching funds": Most LDC governments prefer
not to allow debt conversion proceeds to be used for any imported inputs. Hence, there is an implicit requirement of new money to cover imports. In the case of Argentina, debt conversion coupled with privatization required a combination of debt and new money.
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14. The schedule of capital and dividend remittance: Restrictions on capital repatriation and profit remittance vary widely across different programs. The repatriation guidelines are generally not on terms more flexible than those of the underlying debt. 15. Restriction (if any) on the percentage of shares held in a company through debt equity conversion: In general, investors must agree with the broader framework of the foreign investment legislation of the host country.
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