Argentinas Foreign Debt Restructuring - Essay Example

Case Study: Argentina's Foreign Debt Restructuring Introduction: "President Kirchner sat in Argentina's presidential palace, the Pink House, wondering about the long and winding road ahead. Would the repudiation of most of the country's debt have negative long-term consequences Meanwhile, Argentina's creditors, the international monetary institutions and professional economists were left to debate how such matters should be handled in the future. Were those who lent money to a country like Argentina ultimately at the mercy of that country's politicians What lessons, if any, could be learned from the latest Argentine debt repudiation" These were the questions that remained unanswered at the end of the 'operation haircut' undertaken by Argentina. This paper envisages analyzing the causes and effects of the actions of the political leaders that left to this situation and the circumstances under which the various classes of creditors of the country were forced to accept the proposals put forth by the Argentine president for the settlement of the outstanding debts of the country. Definition of Domestic Debt and Foreign Debt: It is important to understand the extent, scope and coverage of the definitions of the foreign debt and domestic debt before a meaningful financial analysis of the restructuring of the foreign debt by the country Argentina may be undertaken. According to an economic definition "foreign debt is only the debt by non-residents, regardless of whether the debt is in local or foreign currency, whether it is issued at home or abroad. Conversely, domestic debt is debt by residents regardless of whether the debt is in local or foreign currency, whether it is issued at home or abroad. So a Brady held by an Argentine resident is domestic debt while a Letes held by a foreign investor is foreign debt." It is to be understood that the economic definitions of foreign debt and domestic debt are different from the legal definition as had been adopted by the Argentine government for the purposes of undertaking the restructuring of both the domestic and foreign debts. The domestic debt is defined as debt issued according to Argentine law, regardless of whether it is in local or foreign currency and regardless of who, foreign or domestic resident, is holding these claims. Conversely, the "legal" definition of foreign debt is debt issued according to foreign (New York, UK, et cetera) law, regardless of whether it is in local or foreign currency and regardless of who, foreign or domestic resident, is holding these claims." Debt Renegotiation - a Background: Argentina bogged down by its mounting external debts decided to settle all the foreign currency public debt by replacing the debts with new securities calculating at the rate of 35 cents per every dollar of debt. The government also decided to repudiate all the past interest due on those debts. The government also announced that those bondholders who do accept the government's proposal by the deadline will not be paid anything. Though the announcement of the settlement of the debts in this way is criticized vehemently by the bondholders the government announced that by the deadline more than 75 percent of the country's creditors accepted the proposal. However the Institute of International Finance observed that such an aggressive conduct by the government of Argentina was sure to affect its long term economic growth and stability. The Institute also commented on the lack of progress on the implementation of the structural reforms to boost the economic development. Debt Management of the Governments: It so happens in most of the countries the government becomes the largest single borrower of the country. The effectiveness of the debt management largely influences the development of the domestic capital market. The debt management also reflects on the fiscal policies of the country and the spread of the respective countries government bonds in the US and other treasuries world over by affecting the market prices and tradability of the bonds. The debt management policies of the government will have a strategic implication on the growth and development of the economy as a whole. A good debt management of any country should reflect in the reduction of the borrowing costs, greater access to the capital markets of international standing. Such debt management should not affect the private sector borrowing by making a crowding effect there on. Normally any bond issue of the governments should consider the maturity and duration of the issues. There must be a strategic selection of the benchmark which should reflect the choice of the government with respect to the standards set by the government in respect of those characteristics. However the selection of such choices is a complex process and involves consideration of a host of factors like cost of the short term versus the long term issues. There are distinct advantages attached with long term issues as the long term issues has less risks of refunding than the short term issues. Similarly it is much more expensive to develop the domestic currency than borrowing in the foreign currencies. However since there will be a wider investor base borrowing in home currency may as well help in reducing the overall borrowing costs. Important Elements in Argentina's Debt Management Strategies: This section of the paper deals with the characteristics of the Argentine debt market and debt instruments that the country handles including the bonds issued by the government. During the 1970s and 19080s Argentina witnessed a higher rate of inflation and full blown balance of payment issues. Such a crisis situation led to a very poor macroeconomic performance which had the impact of low rate of economic growth and a still lesser level of investment. The government in order to combat the large budget deficits resorted to creation of paper currency. This action was taken in a situation when there was falling of demand for the money locally. This led to a scene of hyperinflation in the 1989-90 and the result of such hyper inflation was the collapse of peso and a further weakened demand for money. There were lot of other measures adopted by the government resulted in a total loss of confidence of the investors in the domestic financial instruments. In some occasions the government thought it wise to reschedule some of the domestic debts and in the year 1989 the deposits in the banking system was converted in to government bonds in a forcible manner. The erosion of confidence in the domestic currency and the problems faced by the country in regaining the confidence in the domestic capital market made the job of bringing adequate capital back into the economy a very difficult task for the government. Impact of Monetary Reforms: The convertibility plans where the government fixed the exchange rate at one peso per dollar with the assurance of the full backing of the monetary base with its own international reserves indicated the start of a new monetary regime. In addition the new charter put in place by the government which had the effect of establishing the independence of the monetary system also helped the new monetary regime to take off effectively. The inflation rate was brought down and there was also the revival of the economic growth by introducing the combined efforts of monetary reforms involving adjustments in the fiscal policies and structural reforms which had far reaching effect. This state of affairs continued only for a little while. Implications on the Domestic Capital Market: The domestic capital was severely hit by the long history of very high inflation levels and the lack of financial discipline in the country. The effect of these factors was that there was a large capital flight out of the country. The Argentines preferred to take their money out of the monetary system of the country instead of keeping that within the country. This was mainly due to the fact that they were worried about the loss of capital due to higher inflation and taxation measures of the government. Though there was no precise measure of calculating the money sent out of the country's monetary system, a rough estimate put at the figure at 60 billion US dollars. This estimated amount is much larger than the amount that was being handled by the Argentine banking system as a whole. The second implication of the prolonged spells of inflation and the resultant devaluation of the currency coupled with the lack of ability of the financial instruments to offer protection to the investors gravely affected the savings of the people. This had the large impact of eliminating peso as a saving instrument. This had also resulted in the emergence of dollar as the currency that had been used as the unit of account and also to store value and cover as medium of exchange. Overall Environment of the Capital Market: There was a drastic change in the overall capital market during the nineties as there were signs of recovery of the macro economy of Argentina and the country could maintain a fixed exchange rate sine the convertibility plan took effect in the year 1991. The convertibility law was instrumental in encouraging the use of the dollar in the monetary system of the economy, since dollar was given an official legal status. This step largely helped brining in much more financial transactions to be done within the country. It also allowed the growth of the domestic banking system and other financial institutions of the country with financial instruments being handled in both the currencies of peso and the US dollar. First Restructuring of the Foreign Debts: The Brady plan was another major step taken by the government of Argentina in restructuring the foreign debts of the government and it helped the country to gain reentry into the voluntary capital market which was hitherto severe hit by a series of economic disorders. This move was intended to provide a long term solution to the debt overhang apart from taking away the uncertainties surrounding the debts which were already overdue and hanging. In the fist such move of restructuring the foreign debt the government offered three different proposals to settle off its debts. A thirty year bond which are at par and discount. In this structure there was the additional guarantee of the payment of the principal through the medium of zero coupon US treasuries. However the floating rate note was of shorter duration and was accompanied by no guarantee. The government also attempted to restructure the domestic debt by reissuing liquid instruments to make good the debts of the pensioners, government suppliers and creditors. Economic Justification for the Restructuring: The announcement by the government to restructure the foreign currency debts by offering 35 percent in full settlement had raised serious concerns among the foreign investors holding sovereign bonds. There had been a demand by some section of the bond holders that they should be offered a better deal than the holders of domestically issued bonds. However this argument did not hold well in view of several arguments that can be offered from an economic angle. The former restructure of the domestic debt was done with the conditions that there was a cap on the coupon rate on the new claims and the full face value of the bonds at maturity could be claimed. However for restructuring the foreign debt the government has announced stringent terms. The announcement made by the Argentina government was close to insolvency. The country reached this stage after a series of economic mal functioning of the monetary systems prevalent in the country and the brunt of such misfortunes were faced by the domestic holders of financial assets. It is agued that the holders of domestic financial assets had already suffered the impact of the real and fiscal adjustments the country had undertaken and hence it is reasonable that the residual burden is shifted to the investors who hold foreign debts of the country. The domestic agents carrying financial assets and other financial instruments in Argentina had suffered and taken to their accounts the economic costs of the negative growth of the economy. The negative growth of the economy as detailed in the case study has made serious economic impacts on the domestic agents which include: Unprecedented increase in the rates unemployment that lead to increase in crimes and low social morale of the people A considerable reduction in the consumption and welfare activities of the government A series of cuts in public services severely hitting the life of the common people Reduction in the amount of public pensions and wages Increased levy of direct and indirect taxes Enormous amounts of capital levies Freezing of the bank deposits belonging to the public Large losses on capital account in respect of equity and real assets Considerable devaluation in the value of peso Capital levies which are absolutely worthless in the shape of pat cones and loops Wilde spread of seizure of pension and other funds Severe loss of foreign exchange reserves Other haircuts on public debts already effected by the government Unsustainable debt servicing costs involved in restructuring the foreign debts The domestic agents in Argentina had taken up the burden of all the above adverse economic impacts to the maximum extent. The residents of the country had been made to absolve the effect of all internal fiscal and real adjustments envisaged by the government to put back the economy in track. Thus it logically follows that once all the available possibilities of internally mitigating the financial issues were undertaken by the government and still there is the eventuality of an insolvency it is for the foreign debt holders to bear the residual cost of brining back the long awaited economic stability to the country at least for medium term if not for a long term. Role of Official Finance in allowing the Early Exit of the Foreign Creditors: In addition to the favor of the domestic agents and creditors taking the burden of fiscal adjustments on behalf of the foreign debt holders, the latter were also protected by the availability of the official finance in the form of International Financial Institution 'bailout' packages which facilitate the early exit of the foreign creditors who were not willing to take up the restructuring options being offered to them. There had been a large use of this source of exit route by the foreign debt holders of Argentina during the early 2000s. Impact of the Foreign Debt Burden: It should be noted that by not resorting to such sort of debt restructuring Argentina would cause 'debt overhang' which would be detrimental to both residents and non residents in their social well being. Taking the logic of demanding more of some thing which is scarce would only lead to declining even the available things, the foreign debt holders should settle for the 'haircut' being offered by the Argentina government. Factors distinguishing True Insolvency and Strategic Insolvency: The true insolvency of a country denotes the inability to pay and the strategic insolvency marks the unwillingness of the country to pay. The argument advanced in this context is that a country may not be in a truly insolvent state but it might follow a strategic insolvency approach indicating its unwillingness to pay just to make greater domestic and fiscal adjustments to enable the country to settle its liabilities in full. But the counter for this argument is that there is no ground that holds this argument due to the following reasons. These conditions essentially apply to the conditions prevailed in Argentina The debt remained so high that it might not be possible for the country to pay off its debts in full even by resorting to any fiscal adjustments on the assumption of an efficient growth. "If the domestic adjustment required to prevent a short run default leads to political unrest (a revolt against further austerity) and a fall in investment that reduces long run growth opportunities, the country is effectively unable to pay as "excessive" domestic adjustment creates political and economic costs that make the debt less sustainable in the medium term." The next point in this context is the availability of empirical criteria like debt ratios to GDP, debt to exports, debt to revenues and debt to primary fiscal and trade adjustments etc which could be used to assess whether the country is truly insolvent or is strategically unwilling to pay Moreover there are market mechanisms and punishments to deal with the strategic defaulting countries' economies. Need for the Haircuts in the case of Argentina: At a certain point the country was lead to such dimensions of debt that the solvency crisis made it self fulfilling and required an ex-post reduction in debt servicing. If the crisis is generated by a fundamental imbalance and a fair degree of insolvency of the country and did not allow the country to pay such higher interests as in the case of Argentina but still remain solvent it is advisable to follow the route of ex post reduction. The action is required to ensure that excessive interest burden is reduced which will have the effect of improving the economic growth and stability. The interest spreads experienced by Argentina made the country to have the component of self fulfilling arbitrariness that required the country to resort to an ex-post haircut so that solvency could be restored in the country even if the country could not be deemed to be completely insolvent. Rationale behind the Haircut: It is important to consider the potentially perverse impact of the interest rate on the debts of the government would create on the debt dynamics of the government. In the case of Argentina since the quantum of foreign debt is more the market would take in to account the cost of the probability that there might not be any chance for the government to service the debts in full and also in a timely manner. Under such circumstance the level of interest rates and interest spreads covering the debt might exhibit the possibility of the country ending up with a partial default of the debts. A partial default may be defined to include a situation where the country is not in a position to service its debts in full. The partial default indicate that the interest rates adjusted for the risk factors would be much higher than under normal circumstances of no default risk. Such higher interest rates would also result in a more rapid accumulation of the stock of debts by a consolidation of the unpaid interest, with the condition that the other economic factors remain constant. "Such an increase in spread may trigger a perverse debt dynamics in which, if the country tries to service its debt in full at current high spreads, debt ratios grow even if the country/government is following policies that are sound and is not otherwise insolvent. One may also end up in situations of "self-fulfilling solvency traps." Hence it becomes imperative that the country resort to some sort of arrangements like haircut to avoid the payment of excessive interest for partial defaults. The 'perverse debt dynamics' could become a serious issue with the countries like Argentina which are in the border line between insolvency and illiquid and are in a deep financial crisis to address. Since the uncertainty surrounding the condition of the country as to its solvency or otherwise is too large and also some of the investors may be risk averse the markets would react to any potential threat of default by the country and thereby increase the spread of the debts created by the government. This might also lead to the worsening of the debt dynamics of the country or the respective governments. This might also throw an otherwise solvent agent in to an insolvency area if the real interest rate is made too high. This is exactly at this point the country Argentina decided to introduce the haircut come what may as otherwise the country would have been pushed to a state of real insolvency creating chaos on the economic front of the country. Impact of Sovereign Defaults: The sovereign defaults have always been found to be messy and especially after the 1930s the countries had taken considerable time to come out of the impact of their defaults to reenter into the capital markets. But it has been proved time and again in the history that the sovereign defaults are not exceptions both under bank and bond financing. Hence the defaults committed by Argentina need not be considered some thing unique and done out of the way. The bonds as opposed to the bank loans had always been considered as a convenient and easy mode of getting the capital into the emerging markets. The handling of the bonds is also considered as more efficient on at times of necessities to substantiate the financial needs of the developing nations. It can not also be said that the bonds are more likely face sovereign defaults. The ex-post returns will be approximately can be considered equivalent to riskless rates and hence the creditors with the guarantee of the sovereign backing would accept the default in most of the cases. The creditors have to accept such defaults despite the fact that they like or dislike such a proposition. It must also be remembered that for a country like Argentina with a large amount of foreign debts, resorting to policies that would accommodate the defaults or alternatively messy workouts which would erode decades of economic growth. Litigation Risk on the Debt restructuring of Argentina: Since some of the creditors were unwilling to accept the restructuring proposal of Argentina, there is a greater risk of those creditors getting into litigation. It is argued that in the case of Argentina such risks of people going in for litigation are far higher than the previous such incidents happened in the case of Ecuador, Russia, Pakistan and Ukraine. The arguments are outlined below: 1. Even when the chances of technical default that may give rise to chances of litigation is avoided by the country, there would be a large number of creditors who would be willing wait till the offer was closed and remain as holdouts. Such holdouts would go into liquidation after the offer is concluded. The situation may turn out worse if Argentina makes a technical default. 2. As compared to the situation prevailed in Ecuador, the proportion of debts is much larger in the case of Argentina. The creditors were increasingly in the fighting mood and the creation of Emerging Market Creditors Association (EMCA) indicated the aggressive and confrontational nature of the creditors in proceeding with the litigation. The case of Argentina could be a good example for other emerging market debtors. 3. The favourable decision of the court in the case of Peru-Elliott had strengthened the claims and fighting moods of the creditors to put forth the litigation of the creditors of Argentina. 4. In the case of Pakistan and Ecuador there were only four and in other countries a smaller number of bond contracts were being the subject of issue. However in the case of Argentina there were 64 different types of bonds that were considered for a possible restructuring. Each one of the bonds was having different terms and conditions attached to the contract. They also would come under different jurisdictions. Hence it was quite practical and possible to find one or more bond contracts with vulnerable terms prone to litigation. 5. "The mega swap in June 2001 has reduced the outstanding stock of previously large issues of debt. A bond with an original issues of $3 billion of face value may now, after the swap, have an outstanding float of only $500 million left in the hand of investors and its market price is even lower than par. Thus, it takes much less for a single investor to take a controlling interest in the outstanding stock of a bond and trigger acceleration (usually requiring a 25% vote) or block changes ("exit consents") in the terms of the bond that do required a 50% or other qualified majority." There were evidences to prove that some aggressive investors have taken this course of action to enforce their holdout rights in case of their refusal to accept the exchange offer. 6. The chances for forcing Argentina by pursuing the litigation strategy to a possible re-opening of the domestic swap to impose a greater level of haircut on the domestic creditors so that the proportion of the haircut needed for the foreign creditors may be reduced to that extent were greater. With this view some of the foreign creditors of Argentina thought it is worth while holding out as a strategy to reduce the impact of the haircut on them. 7. Another point to note is that most of the bonds were issued according to the applicable regulations of New York which do not contain collective action clause and any restructuring requires changes in the terms in a unanimous manner. This would make the restructuring difficult and cumbersome. 8. Moreover the bondholders base of Argentina's foreign debts was very wide with large number of individual investors spread all over in Europe which would hinder the process of negotiating and restructuring their holdings, as it is very difficult to locate them. This issue reduces the chances of collective action of the restructuring difficult and time consuming. However there were counter arguments to the above issues designating them as mere exaggeration or faulty ones. Some of these counter arguments are: 1. In the case of Argentina the exchange offer made included the new price or value at least equivalent to the existing value of the bonds which made the offer irresistible rather than hold out. This situation was quite unlike as it was in the case of other countries like Ecuador, Russia and Pakistan where the terms offered on the new bonds were below the mark to market prices and despite this loss 97 percent of the bondholders accepted the offer. 2. "In the previous four episodes of bonded debt exchange, the holders of the new bonds actually enjoyed major mark-to-market gains in the exchange as the value of the new bonds turned out to be much higher than that of the old exchanged bonds. Such gains were equivalent to over 20% for Ukraine, 32% for Russian Prins and 18% for Russian Ians, 3.5% for Pakistani bonds and averaging over 30% (based on the jump in the price of Bradies, PDIs and Euros after the deal was announced) for the case of Ecuador. Such mark-to-market gains were the result of the relatively generous financial and non financial terms offered to the holders of the new claims." 3. The exchange offer was further made attractive with the addition of the upfront cash, release of collateral and up-gradation of the seniority proved to be an inviting offer for the creditors to take the exchange offer. 4. The necessity for making the terms unanimous or lack of collective action clause was not felt as an obstacle in the process of pushing the exchange offer forward in the case of bond restructuring in the earlier cases of other countries, as these could easily be bypassed. 5. There were a quite a number of institutional investors who were willing to accept a profitable mark to market price in the exchange offer rather than to holdout. These investors tried to induce or bribe the possible holdouts in order to prevent them from disrupting an orderly progress of the exchange process. 6. Being a sovereign debtor, countries like Argentina need not simply bother about the small investors. For instance in the case of Ukraine despite the presence of hundreds of thousands of such small retail investors the scheme went on successfully with more than 99 percent success rate. In fact such small investors did not possess any effective strength or resources to create any harm to the whole process of exchange. Normally such small investors would have been lured into investing in these bonds on the advise of some financial advisor or banks who would equally be interested in seeing to it that the new bonds in exchange were taken by the small investors as there was the financial incentive for them also in the exchange offer. The point to consider was that was there a possibility that the host of factors that facilitate the litigation would disrupt the orderly process of debt restructuring undertaken by Argentina. Without committing a technical default Argentina would be going ahead with the process of structuring and even if some creditors hold out and start litigating, the litigation would take several years for coming to a close. Even if the litigation is started it is not going to hamper the process of the debt restructuring by Argentina. Read More