Wednesday, March 21, 2012

Lessons from Argentina: Sovereign default

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Lessons from Argentina Sovereign default


Argentinas spectacular sovereign debt default may, ironically, change international rules on dealing with such collapses while coming too late for the country itself. Suzanne Miller reports from New York on why the IMF may finally have run out of patience with its old friend.


As Argentinas international investors prepare themselves for one of the most gruelling sovereign debt workouts ever, change is already in the air. Yet that change, which could involve a new set of rules for dealing with sovereign debt collapse, will come too late for Argentina - a country that comprises some 5% of emerging market debt.


Judging from the markets reaction so far, one might think so what? After all, emerging market debt on average has actually contracted 00 basis points to 400bp since Argentina became the worlds largest ever sovereign debt default on November , 001. Just two months later, Brazil and Mexico brazenly issued bonds totalling $.5bn - and investors lapped them up.


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A few lessons are being learnt from Argentinas big mess - the most obvious is that this much-fated country has exposed the myth of too big to fail. It has also blown the notion that the IMF will indefinitely extend lifelines to old friends.


These are some of the reasons Argentinas problems are being seen as a milestone in how debt-diseased economies are treated in the operating room. Forget that the IMF in 1 let Ecuador default on its Brady bonds, which totalled $6bn. That, cynics say, was just Ecuador - one of the small players. But the IMF has advised and lent to Argentina for the past 50 years. At the beginning of last year, the Fund unveiled a $40bn rescue package and another $8bn rescue months later. Why stop now, after Argentina technically defaulted on most of its whopping $1bn in external debt?


After three bitter years of raucous anti-globalisation demonstrations and endless attacks on its bailout legacy, it seems the IMF is finally fed up with doing things the old way. Gone is talk of an imminent Argentina bailout and the implicit bailout for hordes of international investors. The bottom line is that Argentina is broke and it seems as though the investments of many creditors will end up in the same leaky boat.


Argentina is being used as the guinea pig for a new IMF and US policy towards debtors, says Martin Schubert, chairman of the European Inter-American Finance Corporation. Unfortunately, the pain may affect the good and bad in due course - but it is an attempt to get borrowers to adopt acceptable economic and monetary and fiscal policy in the eyes of the IMF and US government, he suggests.


Markets caught off guard


And that is not all. It seems as though the IMFs change of heart also encompasses an entirely new plan for handling sovereign debt defaults. On November 6, the IMFs new deputy managing director, Anne Krueger, did something her predecessors rarely have she caught the markets off guard. At a National Economists Club dinner in Washington DC, she called for the launch of an international workout process to handle sovereign defaults. The message is clear the IMF wants to kick the bailout habit (see page 16).


Critics say the plan is long overdue. Last year, Argentina and Turkey joined a list of IMF bailouts for troubled economies that started with Mexico in 15. In 17, it was Thailand, Indonesia, and Korea and in 18, Russia and Brazil. The bailouts have totalled some $50bn and only added to the debt burden of the countries. They have also done little to solve the underlying economic ills and offered no incentives for creditors to do anything more than cut their losses and run.


Argentinas epic restructuring battle will be fought outside any international court divined by the IMF and its sympathisers, for the simple reason it will likely take years to implement fully. IMF officials suggest the announcement was coincidental with the timing of Argentinas default - that it might even have been delayed had the default made the news first.


This could die a quick death - it is that tenuous, one IMF official says. The obstacles are numerous and the private sector anything but friendly to a third party intervening in its business. Wall Street cannot stand this kind of thing, the official says. The IMF board will debate the paper some time this month and then publish the results.


The secrets out


Yet even if the board dissents, it seems unlikely the idea will disappear, as Ms Krueger has now let the cat out of the bag. This is the very concept that reform advocates such as Jeffrey Sachs, director of the Centre for International Development and professor of international trade at Harvard University, have long championed - so far in vain. Now that the IMFs top management has admitted openly that sovereign restructurings need an international court of law, Mr Sachs is seizing the initiative, along with others who have been trumpeting variations of this theme.


Mr Sachs tells The Banker I am delighted at [the IMFs] initiative - I actually started calling for something like this about 15 years ago. I was very unhappy throughout the 10s when nothing like this existed and countries that had to suspend payments and needed restructurings ended up with very chaotic outcomes.


The Sachs plan


In 15, during the Mexican peso crisis, Mr Sachs advocated a plan that would allow countries to negotiate bankruptcy workouts with their creditors along the lines of a Chapter 11 arrangement in the US, whereby corporations are given breathing room from creditors while working out a restructuring. Then Wall Street and US Treasury Secretary Lawrence Summers torpedoed the idea, and the IMF showed up at Mexicos doorstep with a bailout package.


Now, however, Mr Sachs is contacting colleagues across the country from law schools and economics departments to look at how the IMFs plan can be made to work. I think there are a lot of practical problems but I think it is a viable idea - one that will take several years to bring to fruition, he says. The plan is onerous because it calls for aligning international bankruptcy law at the domestic level. The IMFs Ms Krueger admits that doing this - let along enforcing it - would be an heroic task.


Jubilee Plus, a London-based anti-globalisation organisation, argues that the plan could be implemented with speed if the IMF adopted its suggestions. In mid-January, the group published a lengthy new proposal - Chapter /11 - which aims for a similar goal of the IMF protect countries crippled with debt while they undergo a broad restructuring.


Jubilee Plus plan


But while the IMF envisages the deeply complicated business of launching an international bankruptcy court - one requiring consensus among member countries - Jubilee calls for a far simpler set of rules. It suggests that the sovereign debtor and creditor group each appoint a negotiator and that the two then agree on a third party to act as judge. The Secretary-General of the United Nations would ensure independence of the panel while the IMF rustled up working capital for the country in question.


IMF takes ideas on board


While it is doubtful the IMF would embrace this version, one IMF official says privately that the Jubilee plan has some sound ideas and that it might even pressure IMF shareholders at least to act - much as Jubilee did when it forced the IMFs hand to forgive billions of dollars in developing country debt. The official recalls Jubilee came up with intelligent ideas and put pressure on us and that put pressure on our shareholders.


The IMF has good reason to like snippets of the Jubilee proposal, which at least envisages a role for the IMF - unlike critics who just want to shut it down. On the other hand, the IMF has a considerably bigger vision of its role in this new world order it wants to run the show. These are early days, so it is difficult to predict what the legal framework of the IMFs ultimate plan will look like, for example, how closely it might be modelled on the US-style Chapter 11 system.


Chapter solution mooted


Among other things, the code calls for a standstill period in which creditors back off until the debtors house is put in order. Jubilee has already made it clear it wants a US-style Chapter solution because that law is tailored for municipalities and designed to give taxpayers a voice in the workout process. In other words, under Chapter a municipality puts its citizens interests squarely ahead of its creditors.


Given how successful Jubilee has already been in twisting the IMFs arm, this crusade will not win it many friends in the finance community. But they may be forced to listen just the same. This crisis is different than those of the past because ordinary people across Argentinas social strata do not care what the politicians have to say any more, much less anguished international creditors. Anarchy is in the air and a restructuring plan is nowhere in sight. This in itself marks a change in the way international workouts have always been influenced - by the grown-ups running the country and those financing the machine. The fact that the pots and pans of a population have cancelled hopes of a speedy international restructuring plan plays directly into the hands of anti-globalisers, who have hounded the IMF and its ilk to make globalisation work for the many rather than the few.


Others, meanwhile, already see big holes in the IMF plan. Adam Lerrick, director of the Galliot Center for Public Policy at Carnegie Mellon University, warns that the private market is bound to reject the notion of a system where a major creditor - the IMF - is calling the shots in a workout that is presumably striving for a level playing field.


He says The IMF decides when a standstill occurs and decides when it will end, whether the debtor is negotiating in good faith with its creditors, whether it is following sound policies, whether it can receive new financing. It will also fall to the IMF to pressurise the private market to make concessions. In addition, there will be suspicions that the IMF will not quite kick the habit of favouring countries that the G-7 cares most about. That could create an atmosphere of uncertainty. If there is one thing investors hate more than losses, it is uncertainty, Mr Lerrick says.


Practice, not theory


There are also practical concerns. What happens, for instance, when a country defaults, and after a grace period, and creditors decide to accelerate repayment? Say they get the judgment - how are they going to enforce it? Mr Lerrick reasons that sovereigns have two basic assets outside their countries - international reserves and embassies. These are exempt from attachment under sovereign immunity law so the only way of collecting is to take it to the home country of the debtor and attempt to enforce it, he says. That, of course, could be messy.


Mr Lerrick and his colleague Allan Meltzer, chairman of the same institute, say they have come up with a solution that works within the existing framework - one unveiled in May and simulated in November last year to an audience that included officials from Argentina, the US, Germany, France and the IMF. The idea is to head off the need of a bailout by establishing a so-called orderly framework for a workout - creating a special, temporary market for the stricken countrys defaulted bonds. In this scenario, the IMF would guarantee a minimum price, significantly below the bonds restructured value, to investors looking to sell paper - thereby heading off a market freefall. The guarantee would be lifted once the restructuring was completed.


These are just some of the ideas gathering steam as Argentina sinks. None of them, it appears, will see the light in time to help the country. That means the anarchy of the streets could soon spread to anarchy among the creditors. The indications in Argentina are for a huge mess, Harvards Mr Sachs says. We dont have a legal framework, so we are going to operate ad hoc, hoping bondholders and creditors will act responsibly and not tear Argentina apart in the process - thereby torpedoing their own interests, he adds.


Creditors band together


There are signs that creditor committees are starting to form. In New York, a group calling itself the Argentina Bondholders Committee has been set up, although observers say they represent a tiny number of creditors so far. It is very complicated on the part of the creditors - that is why there has not yet been a large creditors committee, says the European Inter-American Finance Corporations Mr Schubert. [The creditors] are searching for someone to lead - but there arent a lot of traditional leaders from the committees of the 180s and 10s that are still there - the ones that have the kind of experience to face the most complex restructuring ever.


One of the few seasoned hands is Citigroup vice-chairman William Rhodes, who was master of ceremonies for the foreign bank creditors during the 180s Latin America debt crisis and again for sovereign debt negotiations during the 10s. Some officials have credited Mr Rhodes impressive roladex and astute negotiating skills with saving the day for creditors on more than one occasion. It is unclear what role, if any, he will play in the talks ahead. But one thing is clear - Citigroup is facing losses, along with several other foreign banks, which means it will be at the negotiating table.


Foreign banks count losses


In all, there are 1 foreign banks facing direct losses in Argentina. Standard & Poors (S&P), the rating agency, estimates that total losses for this group could quickly reach $6.bn, the total of their loan capital, and easily escalate the longer Argentina stalls on an overall restructuring plan. At this point, S&P says it seems as though the losses are manageable and will not affect any of the foreign bank ratings.


On the other hand, many are estimating that losses will easily surpass $15bn - shaking banks that are already heavily exposed. There are reports that FleetBoston, the most severely exposed of the US banks along with Citigroup, may withdraw from Argentina. FleetBoston, the seventh largest US bank, has $6bn in Argentine loans, including $bn in consumer loans denominated mostly in pesos. These loans, along with everyone elses, have plunged in value since January 6, when the peso was devalued by %.


Then, of course, there are the Spanish banks, the most heavily exposed of all the foreign banks. S&P says the Argentine subsidiaries of Santander Central Hispano and Banco Bilbao Vizcaya Argentaria represent about 4% of their total assets and 7% and 6% of their respective, attributable income.


That is not counting the sea of bondholder debt. Although their numbers are not yet known for sure, some estimate there are at least 150 bondholders around the world holding scores of different Argentine debt issues. Ecuador, which had the dubious distinction of being the first Latin American country to default on its Brady bonds, in 1, had roughly 50 bondholders. Most of these were a fairly homogeneous group of institutional investors. Not so in Argentina, where bondholders are a motley group of vultures, high-yield funds, institutional investors, retail investors from dentists in Belgium to housewives in Japan - you name it. It all boils down to a creditor committees nightmare - if a central committee even manages to be formed.


At the moment, few are feeling optimistic about the gruelling process ahead - much less about recovery prospects. In Ecuador, investors lost roughly 50% of their investment. It is likely to be uglier in Argentina. In a recent S&P conference call with investors and journalists, one hopeful investor asked an S&P bank analyst how much Citigroup might hope to recover. The analyst, suppressing a laugh, replied It is difficult to read - we are looking at what the loss potential is right now.


On January 18, Citigroup said its earnings reflected a negative impact of $470m before taxes because of Argentina. It did not disclose its full exposure. Meanwhile, things are looking downright awful for Argentinas domestic banks. Both S&P and Moodys Investors Service have warned they face insolvency given the lack of a coherent monetary and banking policy framework along with paralysis in the local financial markets. Moodys warns that this is jeopardising the credit health and future of the banking system.


Remember the good times?


How times have changed. It was only four years ago that S&P decided to raise Argentine corporate debt ratings above the sovereign debt threshold and upgrade some domestic banks to investment grade. The simple rationale was that Argentinas dollar peg and its great economic strides had given the country a lasting change for the better. Once dollarisation passes a certain threshold - 40% of measured financial assets - it is difficult to reverse, in part because of the high cost for the private sector of switching back to local currency transactions, S&P explained at the time.


Growth a thing of the past


Since the default, there has been little sign of financial contagion because of market prescience one year ago. But there is talk that Argentina could be facing another lost decade of growth similar to what happened in Latin America in the 180s. If the countrys economic and political plight continues to worsen, there is no telling what Argentinas neighbours might do. Some warn the region could see a return to old-style protectionism as governments bend to popular pressure. This kind of scenario would be grist to the mill of the IMF and its new proposal for an international bankruptcy court.


The situation may lead, as well, to lending with more so-called conscience to emerging markets. That is not to say lenders are about to sympathise with the dispossessed, but that it is becoming too risky to ignore dislocations in countries where yields are rich, debt is outstripping growth, and anger is simmering on the streets. There is clearly room for an international framework that gives breathing room for debt-strangled countries and fosters broad co-operation. That would be a marked change. But anyone hoping for a sanitised solution is bound to be disappointed. In the end, creditors and debtors in high-stakes markets will always be left with messy judgment calls.


As Ukrainian chess master Savielly Grigorievitch Tartakower once said at the start of a game The mistakes are all waiting to be made. In Argentina, the game has only just begun.





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