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A VICTORY BY DEFAULT?
Mar 3rd 2005  

The successful restructuring of Argentina's debts has set a painful new
benchmark for creditors 

IN 1902, after Venezuela defaulted on its sovereign debt, German,
British and Italian gunboats blockaded the country's ports until the
government paid up. In 1881, after the Ottoman empire failed to honour
its obligations, European powers simply seized Ottoman customs houses
and helped themselves to their due. The options available to more than
500,000 aggrieved creditors of the Republic of Argentina, which
defaulted on bonds worth $81 billion in December 2001, were more
limited. After much bluff and bluster, a large majority of them meekly
surrendered their claims before a deadline on February 25th, in
exchange for new bonds worth roughly 35 cents on the dollar.

The giant debt swap is epic in scale. It involves 152 varieties of
paper denominated in six currencies and governed by eight
jurisdictions. These bonds will now be exchangeable for three new
issues. More importantly, the swap carries important lessons for
emerging-market creditors and debtors alike. Bondholder groups think it
a travesty. But on March 1st, Nestor Kirchner, Argentina's president,
declared the restructuring a triumph, claiming "at least 70-75%" of
bondholders had accepted it. As THE ECONOMIST went to press, detailed
figures were still not available, though some reports suggested that
the level of acceptances was even higher than Mr Kirchner's claim.

Even in a default, there is money to be made. So-called "vulture" funds
pick over the non-performing bonds discarded by disheartened investors.
In the summer of 2002, a few months after Argentina stopped honouring
its debts, a brave buyer could have purchased a distressed bond in the
secondary market for 20 cents on the dollar or less. On February 25th,
he could have swapped it for crisp peso-denominated paper worth 35 to
37 cents: a tidy annualised return of 25% or more.

 Not every vulture will settle for such quick pickings. The more
patient among them will hold out for their full pound of flesh in the
courts. They take their inspiration from Elliott Associates, an
American hedge fund that spent $11.8m on distressed Peruvian debt and,
after four years in the courts, forced the government to settle in 2000
for almost $56m. According to Manmohan Singh, an economist at the
International Monetary Fund (IMF), the annualised returns from
successful litigation can be more than 300%. Paradoxically, the higher
the acceptance rate for a debt deal, the better for the refusniks:
governments are more likely to settle with a small minority than with
an army of litigants. 

Elliott Associates did not seize Peruvian customs houses. Instead, it
threatened to dip into the payments Peru made to other creditors
through Euroclear, a settlements system based in Belgium. That legal
avenue has since been closed, but other strategies will be tested,
including a class-action lawsuit in New York. That said, litigants are
likely to be more of a nuisance than a real threat to Argentina.
"Vultures" is perhaps too grand a term for them. To a sovereign
borrower, they are no more than mosquitoes who, as Mr Singh suggests,
can draw enough blood to quadruple in size, but not enough to do real
damage. 

If litigation is more an irritant than a deterrent to sovereign
defaulters, why should they ever repay anything? Several hard-pressed
governments may be asking themselves the same question. "Restructuring
was formerly a taboo word, now it's a topic of open conversation," says
Walter Molano, of BCP Securities. The "haircut" inflicted on
bondholders--the proportion of debt that Mr Kirchner has successfully
written off--sets a new standard. In other restructurings, creditors
have had to accept either a cut in principal, a lengthening of maturity
or a reduction in interest payments. Argentina has achieved all three.

Could Argentina afford to pay more? It managed a government budget
surplus which, before interest payments, was around 4% of GDP last
year, and its foreign-exchange reserves increased to more than $19
billion. With this money it could have sweetened its offer, perhaps by
as much as 3 or 4 cents on the dollar, reckons Vladimir Werning of J.P.
Morgan. But the government would have been unwise, he concedes, to do
much more, committing itself to pay more in the future when it does not
know how much money it will have.

Even after the swap, Argentina's debt will be more than $120 billion
(see chart 1). Indeed, the 152 varieties of bonds eligible for the
exchange amounted to just 55% of its total debt last year. It owes
$13.8 billion to the IMF and another $15 billion to other multilateral
institutions, such as the World Bank. During its economic crisis the
federal government shouldered the debts of the provincial governments
and stuffed the country's banks and pension funds full of bonds, called
BODENs, which were then forcibly converted to pesos.

IN THE LONG RUN
At around 75% of GDP, Argentina's debt ratio remains higher than the
52% carried by its neighbour Brazil. But the interest burden on
Argentina's debts is now much lighter (a coupon of 2-5% in the first 10
years, compared with 10% in Brazil) and the maturities much longer than
the market would normally accept. No big Latin American government has
ever fully repaid a 30-year bond; Argentina has offered a 42-year bond.

 Standard & Poor's, a credit rating agency, has said it will upgrade
Argentina to B- after a successful debt swap, a rating shared by
Ecuador, Suriname and Lebanon. Tax revenues are quite buoyant at
present, but may sag when soya prices inevitably ebb and capacity
constraints bite. The budget surpluses that Argentina requires are not
too onerous at first, but sustaining them may be difficult. The country
needs fiscal stamina, not budgetary heroics, if its debt ratio is to
fall.

Argentina defaulted so heavily because it defaulted so late. Its
descent into default, devaluation and destitution is vividly recounted
in a new book by Paul Blustein (see article[1]). Far from being too
ready to flout its obligations, he concludes, Argentina was too
reluctant to do so. Domingo Cavallo, a messianic politician who
returned as finance minister in 2001, would not countenance default.
"Who could conceive such a destructive idea for a country, and be bold
enough to propose it?" he wrote in the Financial Times.

Mr Cavallo had made his name with his 1991 "convertibility" plan, which
killed Argentina's chronic hyperinflation. The plan removed all scope
for monetary mischief by pegging the peso to the dollar, and making the
currencies freely interchangeable. But Argentina's "monetary
self-denial", as Mr Blustein calls it, coexisted uneasily with its
financial self-indulgence. The Argentine government sold unprecedented
amounts of bonds to foreign investors, accounting at its peak for more
than a quarter of all emerging-market issuance. Its public debt
increased from 35% of GDP at the end of 1994 to 64% at the end of 2001,
nearly all of it denominated in dollars.

Russia's default in August 1998 deprived Argentina of such ready access
to foreign capital (see chart 2). Then Brazil's devaluation five months
later destroyed Argentina's competitiveness in foreign markets. The
country was stuck with twin deficits, a trade gap and a budget gap,
that foreigners were less and less willing to finance. To right itself,
the Argentine economy needed to regain competitiveness. Since the
exchange rate could not fall, prices and wages had to instead. As
recession took hold, peso prices edged downwards, tax revenues faltered
and Argentina's dollar debts grew harder to repay.

With a weak hand, Argentina refused to fold, but kept raising the
stakes. It took on a $15 billion loan from the IMF, known as the
BLINDAJE or "armour", at the start of 2001 and a second $8 billion
bail-out that summer. It completed its notorious "megaswap" of
near-dated securities for longer-dated, higher-yielding bonds in June
2001, buying itself a little time. 

Long before the event itself, it was clear that Argentina had to
default on someone. As the last year of dollar-peso convertibility wore
on, everyone jockeyed to make sure that someone would not be them.
Gerardo della Paolera, of the American University of Paris, and Alan
Taylor, of the University of California, have described the "fiscal war
of attrition" that ensued*[2]. Foreign investors moved their money out;
the unions took to the streets, to forestall a raid on their pensions
or a cut in their wages; the provincial governors kept up their
spending, going so far as to issue their own scrip to fund it;
eventually, depositors pulled their money out of the banks.

BANG, CRASH, WALLOP
In the end, Argentina defaulted on everyone. It stopped servicing its
bonds, domestic and international; it cut wages and raided pension
funds; it foisted its bad IOUs on to one side of the banks' balance
sheets, then made a grab for the deposits on the other side, putting a
freeze on withdrawals. It forcibly converted dollar deposits into pesos
at one exchange rate; dollar loans at another. For the banks, this
"asymmetric peso-ification" was every bit as painful as it sounds.

Must default be this messy? If the process were painless, governments
would resort to it more often. Creditors would then be less willing to
lend and bond finance would be more expensive. The sheer disorderliness
of a default ensures that governments do not resort to it lightly.

A period of exile from capital markets is only the most obvious
consequence of default. The legacy of financial disarray is more
insidious. "Default", write Carmen Reinhart, Kenneth Rogoff and Miguel
Savastano--three current or former IMF economists--"can become a way of
life."**[3] The more often default occurs, the less a defaulter has to
lose, hence the more likely it will default again.

As a consequence, serial defaulters struggle to "tolerate" debt levels
that other economies manage quite comfortably. Their credit rating
begins to suffer even at relatively low levels of debt. The authors
estimate Argentina's safe threshold of external debt at just 15% of
GDP. Although a country's financial tendons may heal suspiciously
quickly, they are permanently weakened each time they snap.

TO DEFAULT IS NATURAL
Andrew Haldane, of the Bank of England, and Mark Kruger, of the Bank of
Canada, argue that "default is a natural feature of the market
mechanism"&#8224;[4]. Default and debt go together like risk and
return. Argentine bonds offered higher yields than American Treasuries
precisely because their promise to repay was not as secure. True, a
more orderly system of payments standstills and debt workouts might
marginally raise the incidence of default. But it would also raise the
recovery rate for creditors. The two effects might cancel each other
out. Default should be avoided at some cost, but not, they write, "at
all costs". 

Reluctant to default, Argentina has been painfully slow to restructure
its debts. Its standoff with creditors has been confrontational, drawn
out and poisonous. When national governments go bust, there is no
impartial bankruptcy court that can resolve their differences with
creditors. But in previous defaults, the IMF has served as a close
surrogate, note Nouriel Roubini and Brad Setser, authors of an
admirably thorough book on debt restructuring&#8224;&#8224;[5]. In
return for a loan, the Fund asks for a given amount of fiscal effort
from its ward, which indirectly determines how much money the debtor
can set aside for its creditors. The Fund, as its governors put it in
an April 2000 communique, "should not micromanage the details" of a
deal. But, some say, it should, nonetheless, offer its best guess of
the country's ability to pay.

This time the Fund kept its guesses to itself. It did not set any
fiscal targets for Argentina beyond 2004 and ventured no opinion on
Argentina's capacity to repay its debts. Messrs Roubini and Setser
accuse the Fund and its major shareholders in the capitals of the rich
world of coming close to abdicating their traditional roles. 

If the Fund has remained remarkably hands-off, it is perhaps because
its hands are not entirely clean. After twice lending money to
Argentina in 2001, the IMF is now itself one of the country's biggest
creditors, anxious to be repaid. In September 2003, it agreed to a new
programme, which, in effect, rolls over the billions Argentina still
owes as they come due. This should have helped it chivvy Argentina
towards a deal. But Mr Kirchner was in no mood to be chivvied. First,
he threatened to default on the Fund. Then last summer, he suspended
the September 2003 agreement, deciding that the IMF's money was not
worth the accompanying hen-pecking. 

In such situations, the Fund is only as strong as its major
shareholders want it to be. Having sided against the Fund in its
quarrels with Mr Kirchner in 2003, the American government's stance
will again be crucial in the months ahead. The IMF must decide whether
to give its blessing to the debt exchange, and what to demand of
Argentina in return for rolling over its debts, $5.5 billion of which
falls due this year. To call the Fund a pawn of the American Treasury
is "an exaggeration," says Mr Blustein, "but not an inordinate one."

How quickly will investors shrug off this encounter with
emerging-market risk? Many already have. Gross bond sales are strong,
and the premium over American Treasuries of J.P. Morgan's index of
emerging-market bonds (the EMBI Global) is just 3.35%--around a
ten-year low.

Indeed, capital markets appear to have a remarkably short memory.
Argentina has defaulted on its foreign debts five times in the past 175
years; Brazil seven times; and Venezuela nine times. A debtor can
default no more than once, unless a creditor is willing to forgive and
forget. Amnesia sometimes sets in remarkably quickly. The bad loans
that Argentina inherited from the debt crisis of the 1980s were written
down in 1992. Just three years later, Argentina was carrying more
foreign debt, both in absolute terms and relative to the size of its
GDP, than it had in 1991.

J.P. Morgan has announced that Argentina's weight in the EMBI Global
will rise from 1.9% to about 2.7% once the latest debt swap is declared
a success. The index weights countries according to how much debt they
have issued. Thus any fund manager tracking the index must, in effect,
lend more to the countries borrowing the most. In the heady days before
its default, when Argentina accounted for 23.3% of the index on
average, the perversity of this incentive was manifest. Purists will
protest that bond prices, like all prices, are set at the margin. As
long as the marginal investor is willing to bet against the index,
prices will not be distorted. But such brave investors may be in short
supply.

AGAINST THE GRAIN
Mohamed El-Erian, an emerging-market specialist at PIMCO, an American
fund manager, is one. He quietly eased his firm's money out of
Argentina a year before the default. Cleaving tight to the index, he
says, is about "personal risk management", not asset risk management.
In other words, a fund manager who does badly when the index falters is
unlikely to lose his job. Departing from the index and then
underperforming is a sure way to get fired. This is why so few other
managers walked away from Argentina earlier.

With real interest rates still so meagre in mature markets, investors
are chasing yield even into territories they formerly scorned. But
emerging markets remain chronically vulnerable to sudden drop-offs in
capital flows. Last spring, for example, when the markets realised
American interest rates were about to turn, a yearlong rally in
emerging-market bonds was undone in a matter of weeks. 

In theory, capital should flow from where it is abundant to where it is
scarce. But Argentina's downfall demonstrates the dangers of relying
too much on this dynamic. In the 1990s, Argentina tried to borrow its
way back to the BELLE ePOQUE it enjoyed prior to 1914, when decades of
foreign investment, anchored by a rigid monetary standard, built the
railways and boulevards that still distinguish the country from its
neighbours in the minds of its citizens. The embrace of the
international bond markets in the 1990s lulled Argentina into thinking
it had left the periphery of global capitalism and joined its centre.

Other developing countries appear under no such illusions. For all the
fear that Argentina's default may have set a precedent, many of its
peers seem to have drawn the opposite lesson from this sorry saga. In
recent years emerging-market countries as a whole have been net
exporters of capital. They have offset generous private inflows with
the prudent accumulation of foreign reserves. With these war chests at
their disposal, countries can insure themselves against the sudden
reversals of market sentiment to which they are still vulnerable.
Emerging markets may enjoy the benefit of recurrent exuberance; they
never get the benefit of the doubt.

*Gaucho banking redux[6]. NBER working paper 9457

**Debt intolerance[7]. NBER working paper 9908

&#8224;Bank of Canada Review[8], Winter 2001-2002

&#8224;&#8224;Bailouts or Bail-ins?[9] IIE, 2004

-----
[1] http://www.economist.com/displayStory.cfm?story_ID=3714880
[2] http://www.economist.com/#footnote1
[3] http://www.economist.com/#footnote1
[4] http://www.economist.com/#footnote1
[5] http://www.economist.com/#footnote1

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