Re­struc­tur­ing debt in the dark

Financial Mirror (Cyprus) - - FRONT PAGE -

As the an­nual meet­ings of the In­ter­na­tional Mone­tary Fund and the World Bank be­gin in Wash­ing­ton, DC, one mem­ber coun­try is con­spic­u­ously ab­sent: Venezuela. Yet there is much to be dis­cussed about the coun­try’s fi­nances. In­deed, a sov­er­eign-debt cri­sis is in­evitable.

All ma­jor sov­er­eign-debt crises of the past – in­clud­ing in Mex­ico and Greece – have gen­er­ated changes in the rules, ju­rispru­dence, or strate­gies adopted by debtors, cred­i­tors, and in­ter­na­tional fi­nan­cial in­sti­tu­tions. Most re­cently, Ar­gentina’s 15-year le­gal bat­tle with its cred­i­tors – in which hold­outs did mea­sur­ably bet­ter than cred­i­tors who had years ear­lier ac­cepted a debt ex­change – desta­bilised the in­ter­na­tional fi­nan­cial ar­chi­tec­ture and gen­er­ated a new set of rules. Venezuela will be the first coun­try to nav­i­gate the new rules; the coun­try can ill af­ford to get it wrong.

Venezuela is in a se­vere cri­sis of its own mak­ing. The gov­ern­ment used the pe­riod of high oil prices from 2004 to 2013 to quin­tu­ple its ex­ter­nal debt, ex­pro­pri­ate sig­nif­i­cant chunks of the econ­omy, and im­pose dra­co­nian price, labour, and cur­rency con­trols. As the price of oil col­lapsed in 2014, the gov­ern­ment, hav­ing lost ac­cess to cap­i­tal mar­kets be­cause of its profli­gacy, chose to con­tinue ser­vic­ing its bonded debt and de­fault on its obli­ga­tions to im­porters and most non-fi­nan­cial cred­i­tors.

The gov­ern­ment also es­chewed both ad­vice and fi­nanc­ing from the IMF, in­stead bal­anc­ing its for­eign-ex­change flows by man­dat­ing the big­gest im­port con­trac­tion in Latin Amer­ica’s his­tory. This caused out­put to plum­met over 30% (ow­ing to the cut in im­ported in­puts), trig­gered 700% in­fla­tion, and led quickly to wide­spread short­ages of es­sen­tials. Among other things, this un­prece­dented skew­ing of pri­or­i­ties led to a col­lapse in oil pro­duc­tion, be­cause the na­tional oil com­pany PDVSA failed to main­tain its pro­duc­tive in­fra­struc­ture and de­faulted on pay­ments to key con­trac­tors in or­der to pay its bond­hold­ers – thereby killing the goose that laid the golden eggs.

Venezuela’s lack of mar­ket ac­cess means that it can­not roll over its obli­ga­tions, ex­cept un­der con­di­tions that worsen its sol­vency, as PDVSA is try­ing to do. Nor can it gen­er­ate suf­fi­cient for­eign ex­change to pay its debts as they come due. So, one way or an­other, Venezuela will need to re­struc­ture its ex­ist­ing debt.

A re­struc­tur­ing is ul­ti­mately in ev­ery­body’s in­ter­est; starv­ing the econ­omy of im­ports merely weak­ens Venezuela’s ca­pac­ity to pro­duce and re­pay. But what tools does Venezuela have at its dis­posal to se­cure a co­op­er­a­tive so­lu­tion with its cred­i­tors in a post-Ar­gentina world? And what role should in­ter­na­tional fi­nan­cial in­sti­tu­tions play to fa­cil­i­tate an ef­fi­cient out­come?

A crit­i­cal com­po­nent of suc­cess­ful debt re­struc­tur­ing is to en­sure that sim­i­larly si­t­u­ated cred­i­tors re­ceive com­pa­ra­ble treat­ment. But this is im­pos­si­ble un­less the “hold­out” prob­lem is solved: if a ma­jor­ity of cred­i­tors agree to re­duce or post­pone their claims, it is al­ways tempt­ing for an in­di­vid­ual cred­i­tor to hold out for full pay­ment by free rid­ing on other cred­i­tors’ pain. That is why bank­ruptcy courts and bonds with col­lec­tive-ac­tion clauses (CACs) seek to im­pose on all bond­hold­ers, in­clud­ing po­ten­tial hold­outs, agree­ments ac­cepted by a qual­i­fied ma­jor­ity of cred­i­tors.

Two things hap­pened in Ar­gentina. First, the de­faulted sov­er­eign bonds did not have CACs, so there was no way to force hold­outs to ac­cept the ini­tial deal. More im­por­tant, years later, US courts ac­cepted a novel in­ter­pre­ta­tion of the pari passu clause ad­vanced by hold­out cred­i­tors (and re­jected by vir­tu­ally all other main­stream par­tic­i­pants and prac­ti­tion­ers in sov­er­eign fi­nance). As a re­sult, Ar­gentina was barred from mak­ing a cur­rent in­ter­est pay­ment to hold­ers of its re­struc­tured debt un­less it si­mul­ta­ne­ously paid the hold­outs the full amount of prin­ci­pal and in­ter­est con­trac­tu­ally owed to them.

Re­struc­tur­ing in the post-Ar­gentina world is made more chal­leng­ing be­cause the hold­outs’ suc­cess in that case means that bond­hold­ers in­clined to ne­go­ti­ate a so­lu­tion will have to ex­plain to their own in­vestors why they are not pur­su­ing the po­ten­tially more lu­cra­tive hold­out strat­egy.

Venezuela’s debt is dif­fer­ent. About 60% of the coun­try’s pub­lic for­eign debt con­sists of bonds, with about half is­sued by the gov­ern­ment and half by PDVSA. With few ex­cep­tions, gov­ern­ment bonds have CACs, mak­ing it some­what eas­ier to ad­dress the hold­out prob­lem. PDVSA bonds have all been is­sued in the US and, as legally re­quired of all cor­po­rate bonds, they do not con­tain CACs.

PDVSA may none­the­less be en­ti­tled to bank­ruptcy pro­tec­tion both in Venezuela and in the US. In this event, PDVSA could ob­tain a court-man­dated stand­still or­der with re­spect to le­gal ac­tion against it un­til a re­struc­tur­ing agree­ment is reached, thereby avoid­ing a dis­or­derly seizure of as­sets.

As an ad­di­tional form of pres­sure to se­cure par­tic­i­pa­tion, PDVSA’s ex­clu­sive right to ex­ploit Venezuela’s hy­dro­car­bon re­serves can be with­drawn or mod­i­fied. (In­ter­est­ingly, both of these pos­si­bil­i­ties are high­lighted as “risk fac­tors” in the of­fer­ing doc­u­ments for PDVSA’s bonds.)

Both PDVSA and the gov­ern­ment can also use “exit con­sents”: chang­ing some of the bonds’ terms – the pari passu clause used by Ar­gentina hold­outs, as well as other sig­nif­i­cant pro­vi­sions – through agree­ment with a sim­ple ma­jor­ity of PDVSA bond­hold­ers and two-thirds of hold­ers of most gov­ern­ment bonds.

Venezuela could fur­ther dis­tin­guish it­self from Ar­gentina by com­mit­ting to a strong re­form pro­gram and seek­ing IMF sup­port. Un­der the IMF’s ex­cep­tional ac­cess fa­cil­ity, Venezuela would po­ten­tially be el­i­gi­ble for more than $70 bil­lion of new fi­nance to sup­port its re­form pro­gramme. And this back­ing should help to win strong sup­port from its cred­i­tors.

In this con­text, the IMF and ma­jor gov­ern­ments should sup­port Venezuela’s de­ci­sion to treat would-be hold­outs no bet­ter than cred­i­tors with which it reaches agree­ment. De­faults stem­ming from an un­will­ing­ness to pay do not de­serve in­ter­na­tional sup­port. But when a debtor is un­able to pay, noth­ing is gained by forc­ing pay­ment. When a sig­nif­i­cant num­ber of hold­outs in­sist on be­ing paid in full, it be­comes im­pos­si­ble to de­sign an ef­fec­tive re­struc­tur­ing, un­less other cred­i­tors re­duce or de­fer their claims. This is the def­i­ni­tion of free rid­ing. No strat­egy to un­der­mine hold­outs can also mean no re­struc­tur­ing at all, which could mean chaos or even a failed state. Nei­ther out­come would serve the in­ter­ests of the in­ter­na­tional fi­nan­cial com­mu­nity or the Venezue­lan peo­ple.

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