By IMD Professor Carlos A. Primo Braga
Once again Argentina is in the eye of a sovereign debt storm, having defaulted on July 30th for the second time in the 21stcentury. This Argentinian default is different to the previous one in 2001 and may have substantive systemic implications. Hopefully it will lead to a fresh look at the idea of a sovereign debt restructuring mechanism.
In December 2001, Argentina was in the midst of a dramatic macroeconomic crisis. Its Convertibility Plan – an exchange-rate-based stabilization program introduced in 1991 – unravelled, leading to the largest sovereign debt default in history. At that time, Argentina owed $9.5 billion to the IMF, $6.3 billion to the Paris Club of official creditor nations, and $81.8 billion (face value) to private bond holders. One can always debate whether a default is driven by unwillingness or inability to pay. But it is clear that in 2001, with a debt to GDP ratio above 80 percent (using real exchange rate values for conversion), Argentina was in a difficult position to continue to service its debt amid political and economic chaos. What followed was one of the messiest debt restructuring experiences ever, with Argentina breaking all standard rules for sovereign debt restructuring and adopting a hard-line strategy towards creditors that paved the way for the current confrontation.
Last week's selective default, however, has some interesting peculiarities. Although the Argentinian economy is deteriorating rapidly, there is no doubt yet about its capacity to pay (assuming that one does not extrapolate retroactively the legal claims of debt holdouts to the whole stock of sovereign debt). In this context, the latest default could be characterized as a clear case of unwillingness to pay focused on a subset of creditors (hedge funds, popularly known as "vulture" funds, that have not accepted the terms of Argentina's earlier unilateral debt restructuring). Or, alternatively, as a case of inability to pay dictated by US law. Accordingly, some have argued that this is simply a technical default driven by a legal confrontation.
Others, however, have argued that this episode may have substantive systemic implications. I side with this second group. Before going through the reasoning behind my position, a little bit of history is helpful.
Debt restructuring Argentinian style
Debt restructuring typically follows a well-known etiquette. The country engages with the IMF to obtain an "unbiased" evaluation of its ability to pay (an Article IV review). Based on such a review, the country offers a proposal to its creditors and negotiates an IMF lending program with adjustment conditionalities. In the case of Argentina in 2001, the government was not interested in an IMF review and decided to make a unilateral offer to bond holders, while postponing negotiations with official creditors.
The restructuring negotiations took longer than usual, and there was no agreement after three years of contentious talks. Argentina then decided to make a unilateral offer to private bond holders encompassing the $81.8 billion principal (face value) plus $20.8 billion of past due interest. The 2005 exchange was able to convert $62.3 billion into $35.2 billion of new bonds, a significant haircut for participating private creditors (roughly 70 percent on a net present value basis).
Argentina's tough negotiating stance was complemented by domestic legal actions enshrined in the so-called Ley Cerrojo (Lock Law) that prevented the government from reopening the offer or making future offers on better terms to creditors. In 2006, Argentina paid in full its debt to the IMF and indicated willingness to renegotiate with the Paris Club. But a group of litigation-prone holdouts (in particular, hedge funds that had bought Argentinian bonds at a significant discount in the secondary market) continued to "harass" the government.
By 2009, as the economic situation in Argentina improved, the government decided to make an additional effort to regularize its sovereign debt situation. The Lock Law was amended to allow for a new restructuring offer, and in 2010 an additional $12.4 billion were exchanged for new bonds with a payment schedule similar to the 2005 offer. With these two offers, Argentina reached a participation rate of roughly 93 percent of its defaulted bonds. However, the Argentinian saga was far from over. Holdout creditors continued litigation in the US as the Argentinian sovereign debt issuances were governed by New York law.
Latin with a New York accent
One of the main actors in this litigation was a unit of Elliott Management (NML Capital), a hedge fund that had begun to buy Argentinian bonds in 1998. Elliot Management had already made history in obtaining a restraining order from a Brussels Court of Appeals against Peru in 2000, forcing Peru to settle to avoid defaulting on its Brady Bonds. The basis for that legal action was an unusual interpretation of the so-called pari passu clause.
NML Capital and other hedge funds pursued a similar strategy against Argentina in New York courts. The Latin expression "pari passu" essentially means "with equal step." This is a standard clause in bond issuances that basically commits a government to treat all bondholders equally. The clause is usually interpreted to apply only to bondholders of the same issuance. To the surprise of most observers, however, a US federal court judge (Thomas Griesa) adopted a broader interpretation of the pari passu concept. He concluded that because of the Lock Law, Argentina had legally subordinated the claims of the holdouts, breaching the pari passu clause (November 2012). Despite a series of appeals, the decision was upheld and on June 16, 2014, the US Supreme Court declined to hear Argentina's last appeal.
Judge Griesa's decision implied that Argentina could not pay the holders of the restructured bonds without also paying the holdouts. In addition, no US financial institution could function as intermediary for the Argentinian payments of the restructured bonds. An alternative strategy, to pay only exchange holders by asking them to trade their NY law bonds into dollar-denominated local bonds, was also blocked by Judge Griesa's ruling. As a consequence, on June 30th Argentina failed a scheduled interest payment of $539 million to its exchange bondholders. In reality, Argentina transferred the money to its trustee (Bank of New York Mellon) in charge of the bond payments, but because of Judge Griesa's ruling, the trustee was not in a position to pay the bondholders.
Accordingly, the clock began to tick in the context of the usual 30-day grace period that follows a missed payment. It is important to underscore that Argentina was in a difficult position because any agreement with the holdouts could trigger the Right Upon Future Offers (RUFO) clause in the restructured debt. This could lead to the acceleration of the exchange bonds under NY law, translating into costs of more than $120 billion for Argentina. Against this background, Argentina opted for a selective default instead of paying the roughly $1.3 billion (plus past due interest) it owes the litigating holdouts. The default became a reality on July 30th.
One could argue that the implications of the Argentinian default will be limited to the Argentinian economy. In other words, the Argentinian saga is an exceptional case and is unlikely to have major implications for other emerging economies – i.e., the risk of contagion is limited. For Argentina, however, the selective default will further delay the normalization of its relations with international capital markets. It is ironic that this is happening exactly when Argentina had finally agreed to repay its arrears to the Paris Club.
An optimistic scenario is that this will be a short-lived default and in 2015, when the RUFO clause expires, Argentina may be willing to renegotiate with the holdouts. But even in this case, the current fragile situation of the Argentinian economy will not be helped by additional tensions with external creditors and higher costs of external financing.
My view is that this crisis has a more subtle systemic implication. Recent bond issuances typically include collective action clauses (CACs) that facilitate restructuring if a qualified majority of bondholders agree to it (typically 70 percent). In this sense, holdouts now have more difficulty in acquiring a strong bargaining position compared with the Argentinian experience – although some analysts argue that CACs without aggregation clauses (i.e., super-CACs, allowing for aggregation of credit claims across different issuances) provide limited comfort to issuers.
Still, the recent legal "victories" for the hedge funds may embolden creditors in future to be more resistant to debt restructuring. They may also affect the attractiveness of New York as a leading jurisdiction for issuance of sovereign debt. In sum, it is time to revisit the idea of a sovereign debt restructuring mechanism as advanced by Anne Krueger, as first Deputy Managing Director of the IMF, in the early 2000s.
Carlos A. Primo Braga is Professor of International Political Economy at IMD, and Director of The Evian Group@IMD. He teaches in the Orchestrating Winning Performance program. He was Director of the Economic Policy and Debt Department at The World Bank from 2008-10. Comments from U. Panizza are gratefully acknowledged.