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Argentine Lessons: Buyer Beware
Latin Finance
December 08, 2006

Five years on from Argentina's $100 billion default, the immense costs to the rest of the world have finally been totted up. Latin America risks paying much more.
Ecuador's 2006 presidential campaign rattled overseas investors with talk of an Argentina-style restructuring. Buenos Aires paid a hefty price for repudiation, but not enough to dissuade other sovereigns from at least considering following suit. A recent study estimates that taxpayers and shareholders worldwide incurred $74 billion in direct and indirect costs from Argentina's delinquency. And there is renewed pressure on the major economies, in particular the US, to make Argentina pay.

Junk rated sovereigns coasting on a wave of excess liquidity have so far been spared retaliation from most investors. But damage has been done to the emerging markets asset class and the questions remain: How much did Argentina pay to scale back its debt by 75%? And will other debtors push for similar relief in the same manner?
Crime and Punishment

Argentine locals protest, but the rest of the world also paid.

Beyond the obvious social costs to the country, Argentina continues to suffer from default. And it has also limited itself to just a few sources of foreign funds, notably the Venezuelan government.

"When you look at how well Argentina's economy is doing now in terms of trade, a fiscal surplus, it's surprising that the spread of Argentina's bonds is 100 basis points higher than the average spread of all the 32 countries in the EMBI Global," says George Estes, partner at GMO, a Boston-based investment house which is a holdout in the restructuring. He adds that only Iraq, Lebanon and Ecuador have higher spreads. GMO has $4.6 billion in emerging markets fixed income assets under management.

"It hasn't been costless for Argentina, they have a distorted economy," says Roger Scher, head of Latin America sovereigns at Fitch. "We've left them in restricted default [rating] until they resolve this hold-outs issue and/or re-access the international markets." Other agencies have promoted Argentina to Single B.

Besides this, new studies by US-based academics quantify the indirect impact on investors and recommend a tougher tack by the US government to bring Argentina into line. Robert Shapiro, co-founder and chairman of advisory firm Sonecon, calculates a direct financial cost to lenders globally of $74 billion net of tax benefits for capital losses. Indirect costs for taxpayers and private shareholders include around $9 billion for US investors with defaulted bonds. Around $2.6 billion was lost by US taxpayers, owing to foregone taxes, according to Shapiro, who served as undersecretary of commerce for economic affairs in the Clinton administration. US firms with direct investment in Argentina also took a hit of almost $8 billion due to devaluation.
"The default and restructuring also generated additional indirect costs for taxpayers and shareholders around the world of more than $63 billion," says Shapiro, who chairs American Task Force Argentina (ATFA). ATFA was launched late in October to try and convince the government of Argentina to reopen negotiations with American creditors holding defaulted debt, and to encourage the Bush administration to reexamine the 2005 debt restructuring as a policy agenda item in bilateral discussions.

The $100 billion question is whether this will deter similar behavior by others. "The economic evidence is on the side that there are no significant future consequences in the credit markets today for defaulting," says Hal Scott, Nomura Professor of International Financial Systems at Harvard Law School. "The costs of over-borrowing on a systematic basis over time are huge and therefore we need a bold remedy," he adds, summarizing a recent paper he wrote about the costs of the Argentine default for US taxpayers and investors.

The worry is that once the markets turn, investors will ultimately penalize emerging markets for Argentina's folly. Investors have been content to take the event as an isolated one that lies off the charts. This may not always be the case. "It has real effects on countries' future access to international lending markets," says Shapiro. "I think you'll see a widening gap in the cost of funds to the bottom half of borrowers as opposed to the top half of borrowers."
Moral Hazard
Argentina has shattered the informal norm of repaying lenders about half present value of their outstanding obligations and getting more than 90% support from creditors for a deal. This could hurt other junk rated sovereigns. "If worldwide lenders come to believe they risk receiving repayments equal to less than 30% of their expected returns, the cost of that lending will rise, squeezing out some developing countries," says Sonecon's Shapiro. He also warns of loss of foreign direct investment.

Given a lack of market discipline from creditors and the near impossibility of collecting on legal judgments, Scott and Shapiro want the US government to take a much stronger line. To start, Scott wants the US to stay out of the courts and not act in support of Argentina. He also recommends barring Argentina access to US markets while working with other nations to prevent it issuing elsewhere. Furthermore, Scott questions whether central bank reserves should continue to enjoy absolute immunity at the Bank for International Settlements. "[We should] explore putting a cap on reserve protection other than for central bank operations, monetary policy and exchange policy. We should remove protection on anything over that," says Scott.

However, this strategy risks driving wayward sovereigns into other financial markets. "A lot of sovereigns would reconsider putting reserves in dollars. They might go to euros or yen. I just think that the cost to the US economy there would be enormous," says Carlos Spinelli-Noseda, a partner at law firm Sullivan and Cromwell. Spinelli was the lead lawyer for Barclays, Merrill Lynch and UBS in the restructuring of Argentina's debt.

Scott also suggests several foreign sovereign immunity act reforms. "We should allow sovereigns to completely waive their rights to the attachment of assets without limitation and that would apply both to sovereigns and central banks," he says. In addition, to expand creditor rights, Scott advises broadening the legal definition of property and commercial activity to help asset seizure by creditors. He recommends that stock of state-owned enterprises be made available for attachment, regardless of location.

Sonecon's Shapiro advocates stopping Argentina's participation in the General System of Preferences, the World Trade Organization exemption, through US government economic and political pressure. "The goal should be Argentina's agreement to rescind its repudiation of the remaining 26% of its defaulted debt and past due interest payments and provide more favorable terms for the holdouts and for those who accepted the original restructuring," says Shapiro.

Besides domestic political opposition to this and legal restrictions, reopening the swap could dent sovereign credit quality. "It would certainly slow improvement in the ratings, possibly even meaning a downgrade because you have the debt burden going up," says Scher.
How Low Can You Go?
Recent history suggests that other sovereigns are not generally looking to follow Argentina's example in terms of repudiation. But there is no doubt that it has set the bar much lower for recovery after default.

"Most sovereigns do not want to go down the path of Argentina, with the possible exception of Ecuador," says Scher. "However, it might affect the calculus of sovereigns once they default." He adds that from 1994 until now there have been just seven sovereign bond defaults in the 100 countries rated by Fitch. In any five-year period, the sovereign default rate was just above 4.0%, versus 2.5% for corporates. "Sovereigns aren't lining up to default, they understand the penalties," Scher asserts.

Recent cases including Uruguay, Dominican Republic and Belize reinforce this. The Uruguayan government chose to cooperate much more closely with investors and was rewarded with a swift return to international bond markets. Says Brad Setser, head of global research and senior economist at Roubini Global Economics: "That is one viable strategy and probably the most common strategy that sovereigns are going to pursue. Why? Because it preserved a functioning banking system inside Uruguay and opting for a different strategy would have had a cost."

Belize is taking a more market friendly tack and even the Argentine Provinces of Buenos Aires and Mendoza did better than the sovereign. Buenos Aires found a strong response in October for a bigger than expected $475 million 12-year bond.

"[The Argentine Provinces] probably paid 100 basis points more than they should have, because of the actions of the sovereign. But just because of being a different entity, they were able to come to the market and work with creditors," says Hans Humes, president of Greylock Capital Management, a vocal holdout in the sovereign restructuring. "Even [the province of] Mendoza, which settled with the holdouts, has relatively unfettered access," says Humes. "When they finally settled with us, we were right on a plane looking at doing direct investment."

Humes hopes for a similar strategy from the republic. "A resolution in a productive way would probably create a dramatic and immediate change," says Humes. Critics of this view say that Argentina is able to issue as many Bodens as it likes and foreign investors will continue to buy, thereby undermining the argument that it has lost access.

Another big issue highlighted by Argentina is how not to come to a restructuring agreement. "A sovereign proceeds with great hazard if it does not consult with its creditors because you will pick up from discussions with creditors a sense of where people are going to shake out in terms of what appropriate terms are," says Lee Buchheit, a partner at law firm Cleary Gottlieb Steen and Hamilton. "You come to a point at which with some degree of confidence, you can say we think the market may accept this deal at this level."

He adds that Belize set new standards for transparency by providing all of the details of its restructuring on the Internet. "My own hope is that that becomes a model going forward because I don't think the process is helping if both sides have asymmetrical information and access to asymmetrical analysis," Buchheit says.
Later Not Sooner
A resolution to the Argentine mess is not on the near term horizon. The sovereign, for one, has little political motivation to settle with holdouts. "We would be more than happy to open up a dialogue and come to a conclusion as soon as possible," says Humes. "The ball's in Argentina's court."

Shapiro says a lot will depend on external pressure and concedes that Argentina is unlikely to change its stance until after the election. "There is certainly more interest in this now in the US government . . . both in the administration and in Congress, than there was a couple of months ago," he told a panel in October.

"Inflation's going to be a key driver," says Scher, pointing to double digit inflation in Argentina. "The one thing you can say about Latin America is that there's an anti-inflation consensus. If inflation starts eating away at the real wage of Argentines, they are going to re-elect a Menem-Cavallo type team in the future that will possibly want to deal with the holdouts," says Scher.

Meanwhile, a pact with the Paris Club looms. Bondholders expect it to take the usual line and get a better deal than bondholders. "This case will have important implications for the Paris Club and how it operates in the future," says Lex Rieffel, non-resident senior fellow at The Brookings Institution. "The best outcome is for the Paris Club to say we're not going to do a deal with you until you settle with the holdout bondholders."
Caveat Emptor
The bottom line is that until the bull market ends, Argentine government funding needs will not seriously be tested. As its GDP growth accelerates albeit from a low base and the ratings creep back up, Argentina has become the focus of yield hungry lenders, many of them flush with cash generated by a protracted low interest rate environment. Buyers are barely factoring recovery values into their risk-reward models and although the government is still having trouble getting a Global bond off the ground owing to attachment risk, it is finding a strong bid for domestic debt.

And foreign governments, bondholders and courts can say what they like. Argentina's default proved primarily that in this era of post gunboat diplomacy, you can never force a sovereign to do what it does not want.

"It does show how hard it is for creditors to recover in a default, and how foolish it is to ignore the risks of lending to some sovereign borrowers," says Rieffel.
Adds Shapiro: "Any country can pursue anything it wants in the world, no matter how ill-advised."

Sovereign bond prospectuses are quite clear about the risks and shortcomings of the legal system in the event of a default, although retail may not be quite as rigorous in reading and understanding them. As a precedent setter, investors should look beyond the end of the cycle and consider what they can accurately expect to salvage from a repeat performance by Buenos Aires, Quito or others in Latin America. Above all, they should remember the principle of caveat emptor. LF