Argentina’s default explained

Last week, Argentina defaulted for a second time. What are the implications for the country – and for the rest of the world? Matthew Partridge reports.

What happened?

Argentina was declared to be in ‘selective default’ by Standard and Poor’s last Thursday. This took place after a deadline imposed by a US court to reach a deal with holdout owners of government bonds expired. (The ‘holdouts’ are owners of bonds who have refused to accept interest-rate cuts agreed as part of two rescue deals for Argentina.)

The problem is that, due to the court’s ruling, Argentina is legally unable to make payments to the rest of its bondholders without the permission of the holdouts. In turn, the holdouts are demanding that the country first honour pre-2001 bonds with a face value of $1.33bn (plus interest).

With the US Supreme Court refusing to hear the case, and the judge refusing to stay the ruling, Argentina claims it has no option but to default for the second time in just over 12 years.

Why did it default in the first place?

During the 1990s, Argentina made the controversial decision to peg its currency to the dollar. This cut inflation and allowed large sums of foreign money to flow into the country, causing an economic boom.

However, it also encouraged public spending to spiral out of control – especially spending by regional governments. Argentina quickly found itself with large amounts of public debt. When the US started raising interest rates in the late 1990s, Argentina was forced to follow suit to maintain the peg.

At the same time, in an attempt to meet its obligations to debtors, it slashed public spending. This caused a brutal recession, with unemployment reaching 18%. Argentina was faced with a public angry at the economic collapse and an even worse fiscal situation.

Despite two assistance packages from the International Monetary Fund (IMF), Argentina was forced to default, devalue its currency and impose capital controls.

Why is this still dragging on?

Argentina’s radical steps helped its economy recover. However, creditors lost large sums of money because they were forced to accept new bonds with total interest payments equivalent to only a fraction of the original face value of their bonds (around 30%, on average). With encouragement from the IMF, most (92%) of the private bondholders eventually accepted these ‘haircuts’, in two rounds of settlements in 2005 and 2010.

However, a small minority refused to do so. Sensing an opportunity, NML Capital (a so-called ‘vulture fund’) bought these bonds very cheaply after the default when they were nearly worthless, hoping that it could get a better deal if it held out.

It then proceeded to sue the Argentine government in various courts around the world for either payment in full, or the ability to seize equivalent assets. While its attempt to seize an Argentine naval training ship docked in Ghana was eventually declared illegal, and it was rebuffed in Germany, it has found success in the US.

Couldn’t Argentina just pay it off?

In theory, it should not be particularly difficult for Argentina to pay NML off. Indeed, the entire amount of money that NML is demanding is equivalent to just 0.2% of Argentina’s GDP at current exchange rates.

However, Buenos Aires believes that it would be unfair if it spent large sums of money to repay people who bought the bonds cheaply, after Argentina had defaulted.

More importantly, it is concerned that settling with the holdouts would encourage other investors to file lawsuits seeking to renegotiate the deals that they previously agreed.

How will this affect Argentina?

In the short term, the impact on Argentina’s economy should be minimal since the country is still barred from international bond markets.

The fact that the default is due to a legal technicality, rather than a lack of money or an outright refusal to pay, means that the other bondholders should not be too worried. Overall, the stock markets have barely been affected, suggesting that the default was already priced in.

However, as The Economist points out, most of the post-haircut bonds give the holder the right to demand immediate repayment in the case of default. While bondholders are unlikely to exercise this right immediately, the chances of a rush for the exits will increase the longer this drags on.

Are there implications for other countries?

Debtor countries are concerned that if NML wins its case, or forces Argentina to back down, it could have implications for similar lawsuits against Grenada and the Democratic Republic of the Congo. They are also are concerned that in the longer run it could become much harder to persuade bondholders to accept haircuts in any future debt renegotiation.

What are vulture funds?

Most sovereign debt is now issued through the bond market, rather than via banks. This means it’s much easier for bondholders to sell their debt to third parties, instead of having to hold it to maturity. This increased liquidity has helped countries to borrow more cheaply.

The trouble is, because the holdings are dispersed, it’s harder for a country to get all its creditors to agree to restructure its debt. Enter vulture funds, which buy the debt of countries in default cheaply, refuse any negotiated offer, then pursue the countries in courts around the world.

The funds hope that the countries will eventually settle, allowing the funds to make a large return. The African Development Bank Group estimates the cost to debtor countries can be as much as 12%-13% of GDP.

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