Monday, November 24, 2014

Argentina’s Sovereign Bondage

WASHINGTON, DC – Sovereign debt has been back in the news recently, this time because of a United States Supreme Court ruling concerning Argentine debt. As a result of the ruling, a complicated issue is likely to become even more so.

Sovereign debt has been a major feature of the international financial system for centuries. Kings borrowed, often internationally, to finance wars and other expenditures. When they couldn’t pay, as sometimes happened, sovereigns defaulted.

Today, sovereigns are more often democratically elected governments, but they still borrow. And they still occasionally find themselves in situations in which their debt has become unsustainable and they need outside help to continue to meet their debt-service obligations.

When private firms (or subnational governments) become insolvent, there are normally legal bankruptcy procedures to determine what to do. Without such procedures, a market economy would be unable to function.

In part, this is because creditors would otherwise stop extending credit and demand repayment at the first sign of trouble. This is because the first creditors to be paid would receive the full amount owed to them, leaving less for later creditors – and thus creating an incentive for all creditors to rush for the exits even before debt servicing had become impossible.

Moreover, in many cases, the value of the troubled entity’s assets as a going concern is greater than it would be if the assets were sold separately. In such cases, all creditors would be better off with a debt write-down than with dissolution. Bankruptcy law thus protects creditors from each other by preventing an outcome that would needlessly harm all of them.

In the case of sovereign debt, however, there is no binding international law that permits bankruptcy. Though some routine practices have emerged as international capital markets have grown, they remain ad hoc. Given the uncertainty involved, and that sovereign debtors can repay domestic-currency debt simply by printing money, creditors have typically demanded significantly higher interest rates if bonds are not issued under the law and in the currency of an advanced country – often the United States or the United Kingdom.

When a sovereign decides that its foreign debt is unsustainable, the government and its creditors have had to negotiate among themselves about what to do. For sovereign bonds held by other sovereigns, the Paris Club of creditor countries has developed procedures for handling the debt. But when private creditors hold sovereign debt, organizing them creates a new challenge with each episode.

When debt is unsustainable, there are several possible negotiating outcomes. Sometimes, debt-service payments are rescheduled and perhaps stretched out over a longer period, thus giving the debtor country time to regain its ability to pay. Sometimes, creditors agree to exchange the old bonds for new ones, which have either a lower face value or lower interest payments. Few governments refuse to pay at all in any form.

Argentina defaulted on its debt in 2001. After several difficult years, the country managed to negotiate an exchange of outstanding bonds for bonds with a considerably lower face value. About 93% of creditors accepted the exchange and received new bonds with a face value that was about one-quarter of that of the old bonds. After 2005, Argentina maintained debt service on the new bonds.

But some creditors held out, and sued Argentina in New York (as the bonds were issued under New York law). Argentine bonds (like most others) had a so-called pari passu clause that committed the government to treat all bondholders alike. The holdouts claimed that, if the new bonds were being serviced in full (as they were), equal treatment required that the holdouts should receive the full amount owed to them (including not only interest but also principal).

The US Second Circuit Court of Appeals ruled that Argentina was bound to honor its obligations to the holdout bondholders in the same proportion (namely 100%) as the holders of the exchange bonds. It was that ruling that the Supreme Court recently upheld.

Under the court order, Argentina may not pay the holders of the new bonds unless it also pays the holdouts, and no US financial institution can serve as an intermediary to make payments for Argentina. As a result, Argentina must either pay the holdouts in full or default on the new bonds.

Regardless of how the current impasse is resolved, the ruling raises many questions for issuers and holders of sovereign debt. If creditors now believe that holding out makes it more likely that they will receive full value at a later date, restructuring sovereign debt and restoring a debtor economy’s normal functioning will be more difficult.

Since the Argentine crisis, most new bonds have been issued with collective action clauses (CACs), under which bondholders are obliged to accept restructuring if a specified share (usually around 70%) agree to it. As time passes, there are fewer and fewer outstanding bonds that do not contain CACs. But CACs may not resolve the problem entirely, because a vote would be required for each separate bond issue, and a holdout position could be achieved by buying up the blocking percentage of a small issue.

It is also possible that language will be found in future bond issues that replaces the pari passu clause but provides sufficient assurance to bondholders to let the market function much as it did until the current ruling.

Until the euro crisis, it was generally believed that problems servicing sovereign debt occurred only in emerging markets and the least developed countries. The US Supreme Court’s decision on Argentina adds a new wrinkle, and may well further increase the risk attached to holding sovereign debt – and this to the cost of issuing it.

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    1. CommentedStephen Martin

      Today, sovereigns need to get good advice before they decide to borrow internationally and when they are documenting the borrowing.

      Point 1
      When Argentina devalued, deposits and later loans that were controlled by their legal system and denominated in dollars were immediately switched to pesos at imposed rates of exchange in order to prevent the dollars from being withdrawn. Among the people who had dollar accounts at the time, the imposed rates benefited the friend of government borrowers and cost the middle class depositors. Foreign currency obligations controlled by NY law and European law were not converted but would be harder to service in the future as a consequence of Argentina's inability to restate them into the local currency at a rate of exchange it could impose.

      Point 2
      Argentina did not exersize a lot of thought before making decisions during the period of its devaluation. Lenders take that profile into consideration when pricing their loans and computers now enable more precise and longer lasting fact trails than existed when former sovereign defaults were discussed.

      Point 3
      Countries who borrow in the international markets receive a lower rate for independent control because investors value the independence of the offshore legal process.

      Point 4
      Omissions and mistakes matter when documentating a credit relationship.

      Point 5
      These days there are investors who look for unidentified mistakes and buy bonds cheaply when they find one. These investors will benefit in the future from advances in communication. The mistake is more valuable to them in a jurisdiction which applies the law without consideration of the consequence.

    2. CommentedFernando Ferreira

      Neither courts nor coasean agreements provide at least 2nd best solutions. Is It time for IMF to draft the guidelines?

    3. CommentedJonathan Lam

      Gamesmith94134: Argentina’s Sovereign Bondage
      “Given the uncertainty involved, and that sovereign debtors can repay domestic-currency debt simply by printing money, creditors have typically demanded significantly higher interest rates if bonds are not issued under the law and in the currency of an advanced country – often the United States or the United Kingdom.”

      As an institutional investor, I would protest on the issue of standardizing value on the bonds that are pegged to dollar or pound; in which, IMF has neglected the significance of the local pricing system which has made BRICS to fall after the invasion of the local equity market that created a stagflation and depreciation on the local currencies. Of course, it was the Quantitative Easing that triggered “beggar thy neighbor” and the concurrent environment that pushing the equity market to double its value in both developed nations and EM nations which have acclaimed disinflationary measures works. Hereby, I would warn both US and United Kingdom that their equity market are now being invaded as well, that inflation and inequality would depreciate their currencies and societal disorder is startling to rumble. Perhaps, EU is questioning the Conglomerates on the Taxes and privileges to restore its strength; and its double digits returns are undermined. After the 17000 in DJ, I would doubt the undeterred perpetual growth in price and how the market react on value of these stocks—diasporas or depreciated after widened trade deficits.
      It is the market system that IMF must contemplate how the prudent macro-economic in the coming round of throw weight accountability of the currencies exchanges. How does IMF treat currencies in Developed nations and EM nations like protein in meat or fish alike that make it impossible to account 0.75% and 7% as in market rates by lumping together in such so-called market system? It is discriminating from one market system to another if the exchange rate is standardized with the globalized economy; and there is no one market system going to fit for all.

      “Under the court order, Argentina may not pay the holders of the new bonds unless it also pays the holdouts, and no US financial institution can serve as an intermediary to make payments for Argentina. As a result, Argentina must either pay the holdouts in full or default on the new bonds.”

      It is why I would agree that zone development to trade should be applied in the 1% in the transcontinental investment and another 1% for Diasporas for profits to levitate the exchange differentials; so, it would ease the tension of the strategy of “beggar thy neighbor” in fund transfers and devaluation of local currencies. Such issue cannot resolve with bankruptcy court since the sovereign is not marketable and vulture fund to manhandling the discounted bonds be not be rewarded with its full fund. Eventually, each trade group of the Zone can utilize these 1% funds to balance the exchange trade off, and the contingency that the bonds can buy back or subsidized to renew its bond issues through the zone authority through the WTO commissioned and World Bank guaranteed through the sovereign bonds, instead of kicking the can down the road or snowballing the debts to unsustainable. In the process, we, the institutional investors can purchase these bonds with local currencies and demand the debtor sovereign to participate the 3% loan with another 1% payment on the insurance premium to World Bank and IFC to work on the coupon issues to repayment and supervision to how the bond is pegged to it tax program or utility fee. Perhaps, we can eliminate the casino type investment from the stronger currencies and holdouts. Then CAC would not be needed or challenged in litigation; instead of using austerity to starve of the local economy.
      At present, I would encourage the institutional investors to participate in the WTO commissioned sovereign bond programs that my 3% return is ascertained with its 1% funding to ensure its payoff. I suppose such 3+1% is still cheap as comparing to the local loan rate; and it fitted for reviving the local in a breathable manner rather than a chokehold in depreciate its currencies to qualify to newer issue of sovereign bond and our investment are the real capital that are earned or accumulated through the process of valuation; they are matured cash value. By comparison, restructuring bonds are using the deferential interest rates and exchange rate to manipulate the local market system that is just assets by its shell only. I bet my finger is better than the bet off the broker; and it is not market system. It was Casino like Las Vegas.
      I think I have out-spoken on the issues; but why should I second guess what the bankruptcy court could have offer for the investment on the debts which is sovereign or not; and my pension fund are real capital when it compare to those loans of the cheaper cost from the FED.
      We do need reform even for Developed nations too, and the secondary central Bank from World Bank and Zone insurance should be considered……..and now before the diasporas. It may not happen because Ms. Yellen believe US can do hold with DJ; but trade deficit, inequality and over-valued stock price could be another factors in being depressed.
      May the Buddha bless you?

    4. CommentedClaudio Migliore

      Is it acceptable to wonder why it is a bad thing that the risk of holding foreign debt and the cost of issuing it rise?
      I am sure the risk of holding Swiss or even Australian debt is not likely to rise substantially. And if such risk and cost rise for countries like Argentina or Zimbabwe, maybe that may lead to a better allocation of investment and better long term behaviour of all sovereign borrowers. One could claim that this would come about on the skins of Argentine and Zimbabwean citizens, but others might say that the moral hazard that raises risks is related to the appropriation of resources by ruling government bureaucrats and not the investments in bridges and vaccines.