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Three Innovative Financial Instrument

joeleebassy | Jan 25, 2010 |

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Three financial instruments that are increasingly used in domestic financial markets (notably the mortgage market) have not yet been used by developing countries, but may have certain merits for them.

(1). Flexible maturity loans. Instead of variable interest rates, loans carry a variable maturity. Debt service payments are held constant in absolute terms (or, perhaps, in relation to a borrower's income). When interest rates rise, the amortization part of debt service declines and the loan's maturity increases accordingly. With a large rise in interest rates, negative amortization will occur; lenders will effectively be providing new money to borrowers. Flexible maturity loans offer advantages to both borrowers and lenders. Borrowers are certain of their debt-servicing obligations. Lenders are able to manage their assets with less worry about debt rescheduling and possible write-off. For developing countries, this would be doubly attractive if debt service payments could be over volatile commodity prices.

(2). Graduated payment loans. Debt service payments are initially low and gradually build up. In the early years of a loan, amortization may even be negative. This instrument could be particularly suitable for project finance, where earnings and debt-serving capacity rise as project matures. By matching the stream of debt service obligations with the expected foreign exchange earnings of a project, debt managers would avoid typing up foreign reserves for debt servicing.

(3). Shared equity loans. Lenders would accept below-market interest rates in return for a share in the equity of projects. For the borrower, the risk involved in a project is shared with the lender. However, since a project's earnings depend on what price is charged for its output, a loan agreement would have to contain some pricing formula. This would give lenders some influence over the management of the project (though it would also raise their administrative costs). Lenders might also want to stipulate some compensation procedure or insurance against political risks.