Ar­gentina’s sov­er­eign bondage

Financial Mirror (Cyprus) - - FRONT PAGE - By Anne Krueger

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, or­gan­is­ing 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 achieved by buy­ing up the 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. could be block­ing

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