Sovereign debt is a crucial lubricant for growth, especially among emerging nations, and so it is equally crucial that we can ensure the interminable row over Argentina’s default is not repeated. Measures proposed to do just that, however, might just make things worse.
Argentina’s latest default (its eighth) has at least sparked key players into action. According to a report in the Financial Times, the International Capital Market Association (ICMA), whose members include banks, investors and debt issuers, has created fresh clauses for inclusion in sovereign debt contracts that will give countries the option to bind all investors to decisions agreed by the majority.
It is an effort to keep the wheels turning smoothly in international financing: Just as a new company requires loans to start up, emerging markets must depend on richer countries to fund their development needs.
But, just as a company may go bankrupt because of external factors, a country may be faced with economic crises that make it difficult to repay the debt. A company in that situation can declare bankruptcy and reach a deal with creditors to restructure or sell assets in a deal brokered by the local courts. When the same situation faces an entire nation, there is no international court that can enforce contracts between creditors and debtors from different countries. This lack of enforceability creates a host of problems.
Credit where credit’s due
A natural question is that if creditors are aware of the non-enforceability of contracts, why would they lend in the first place? And how can sovereign states then raise funds? The obvious answer is reputation for repayment. If a country shows that it is credit-worthy because it repaid loans in the past, then this reputational capital may be used to attract funding. In principle, a better credit history may imply better terms of repayment – and we can all relate to that.
However, this relies on the creditors being able to punish the debtor country effectively once default occurs. In other words, if there is no punishment after default, then the signal is that debt will be forgiven in any case and may lead to less effort to repay on the part of the debtor country. This undermines the reputation mechanism and is a particularly salient issue when there are multiple creditors, as in the case of most sovereign debt, and notably Argentina.
Argentina’s experience has acted as a pretty thorough examination of the flaws in the current system. In 2005, at the time of the last crisis, the country had agreed on reduced debt servicing with the vast majority of creditors (75% of the defaulted bonds). In 2010, another 17% of the original bond holders agreed to the new terms. Thus all but a small minority of the bondholders agreed to a proposed “haircut” on their debt which essentially meant creditors sacrificed 35% of what they were owed.
Out for blood
The 8% of bondholders who did not accept the terms, “vulture” investors like Elliott Associates, specialise in buying up cheap debt and seeking full repayment when the country comes out of the crisis. They sued the Argentinian government for full repayment plus the interest accrued (about $1.5 billion). Had the debt been issued in Argentina, it would be handled by judges within Argentina. The problem was that the debt was issued in New York and thus subject to the American judicial system (this made it cheaper for Argentina to borrow money).
Judge Greisa, the governing judge in the case, has ruled in favour of the vulture funds and has prevented Argentina from paying back the restructured debt to other creditors until it pays the full amount asked for by Elliot Associates. This has virtually sent Argentina into an involuntary default.
So, what’s going to happen now? What can Argentina do? Standard and Poor’s has already downgraded Argentinian debt. Usually, as after the Greek crisis, a downgrade means that countries can only borrow at very high rates of interest. In the case of Argentina, this may not happen because investors realise the reason for the default is not in Argentina’s control. If Argentina were to do what Judge Greisa has ordered, it opens itself up to a spate of legislation from other creditors, making another default inevitable.
The main problem lies in the inability to make creditors agree on the restructuring deal. The latest proposal from the ICMA has been suggested before and has some broad support, even if some fine turning of the new clauses for insertion in contracts would be required to deal with multiple bond issues and all debt. The proposed solution would bind all creditors to a vote that is agreed to by at least 75% of the creditors, instead of 100%. The idea is that this reduces the incentives to hold out. Some countries, such as the UK, already employ these clauses.
While this approach is promising, the trade-off is that debtor countries may default more readily knowing that restructuring can be agreed to more readily. This in turn may discourage creditors from lending in the first place. The new clauses, after all would not address the lack of enforceability of sovereign debt, and so we are left to see how they impact on the reputational mechanism instead.
The change in the voting threshold implies that the value of distressed debt will be higher, thus reducing the incentives of vulture funds to buy it. This can only be good. However, will the new clauses improve creditor coordination? And what if, instead of faster agreements, the bondholder composition becomes more concentrated and more creditors decide to hold out? The risk lies is not quite knowing whether a new regime would lead to a different, and more coordinated group of creditors, and not knowing which way they might act.
The second point to make here is that the revised contracts will have to wrestle with age-old dilemmas over the balance created in such debt deals. If bankruptcy laws favour the debtor too much, it creates incentives to misuse them and in turn discourages banks and investors from lending. If the law favours creditors too much, then it reduces the incentives to borrow money and reduces the potential for innovation and entrepreneurship. Sovereign states and the financiers know this only too well, and no single clause will be a cure-all for the kind of predicament faced by Argentina.