An Americancourt ruling has demanded that Argentina pay up for past debt defaults. What happens next could have a big impact on bond markets, says James McKeigue.
What's happening?
Argentina could be heading for another default. It's not that the country is running out of money, but rather that President Cristina Kirchner may decide she'd rather refuse to pay up than give in to one set of angry bondholders.
The story begins in 2001 when, with its economy in crisis, Argentina defaulted on almost £100bn of foreign loans. Since then Argentina has cut a deal with around 93% of bondholders, agreeing to pay back a third of the debt. But the remaining 7% refuse to accept.
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Why are they holding out?
The holders are hedge funds which some call vultures' who target distressed debt and buy it at a fraction of the original price. They then demand full repayment (see below), resulting in a huge profit. The funds have harried Argentina in the international courts for years, trying to force it to settle up. Just last month they persuaded the Ghanaian High Court to impound an Argentinian naval frigate docked there.
Last week the bitter battle appeared to enter its closing stages when an American judge ruled that Argentina must pay the vultures $1.3bn. What makes this ruling stand out is Judge Thomas Griesa's insistence that, if Argentina doesn't make the extra payment, the vultures can take what they're owed from Argentina's next scheduled payout to restructured bondholders.
Argentina is due to pay $3bn on 15 December. If it doesn't put in enough extra money to cover the vultures then following a 30-day grace period it will be classed as a default.
What will Argentina do?
Argentina has appealed. But if the ruling stands, Kirchner has three options: pay up, default, or try to circumnavigate the country's existing bond payment mechanism in America. Right now, default looks most likely.
Argentina could make the $1.3bn payment quite easily, but Kirchner favours an aggressive, nationalist foreign policy to curry favour with voters at home, and her hardline stance against the vultures was going well until the frigate debacle.
Backing down would be embarrassing, and could also open the door to claims from other such funds. Some argue that Argentina could get around the ruling by persuading restructured bondholders to take payment in Argentina instead of the US.
However, this is uncharted territory. Michael Henderson from Capital Economics notes: "In all likelihood, any such attempts would end up triggering" a default anyway because they break the original terms of the bond.
Would an Argentinian default matter?
It wouldn't be good for the 93% of bondholders who have already agreed to restructure. Some of them have also appealed against Judge Griesa's decision. Beyond that, the impact on Argentina wouldn't be that dramatic. The country has been pretty much barred from international debt markets since the last default, so its ability to borrow isn't at stake. Because few investors hold Argentinian government debt, the international fallout would also be limited.
But the terms of the ruling could have greater consequences for the wider sovereign bond market. For one, this deal makes those who have already settled with the Argentinian government for far lower payments look pretty stupid. So in future, bondholders may be less willing to negotiate with bust governments.
Stephen Choi, a law professor at New York University, fears the decision will "reduce the ability of sovereigns in economic and financial distress to engage in efficient, value-increasing restructurings". That could be particularly important for Europe, where several of the solutions' to the region's debt crisis involve private bondholders accepting reduced returns.
Are there any other concerns?
Argentina has a history of defaulting, so its bonds are deemed more risky than US or UK government debt. So, just like other emerging markets at the time, Argentina offered a higher yield to compensate for the risk. The current ruling risks undermining this core principle, says Mario Blejer, a former Argentinian central banker, in the FT: "If investors are willing to accept higher risks... to cash in on the additional spread, they cannot renege on the potential cost when the risk of default becomes a reality If all holdouts are eventually paid in full, the entire price-setting mechanism in sovereign bond markets is rendered inconsistent."
The case may also change where countries issue debt, and the conditions attached. This case is being decided by US courts because that's where Argentina issued the bonds. Argentina also failed to include a collective action clause (CAC) in the bond. If it had, it could apply majority rule to all holders. So CACs may become a staple feature of future bonds, which could in theory raise borrowing costs.
Who are the vultures?
The best-known is Paul Singer. The American financier founded Elliott Associates in 1977 with $1.3m. His tactic of buying debt for pennies, then employing lawyers to realise its nominal value, has helped the firm become America's ninth-biggest hedge fund. Sovereign debt is a small portion of his portfolio, but Singer has won some notable victories.
In 1995, Elliott bought defaulted Peruvian bank debt for $11m and successfully sued for $58m. Another of his companies made a killing on debt issued by the Republic of Congo, using international courts to claim proceeds from the country's international oil sales.
One of Singer's firms NML Capital Ltd reportedly stands to receive about half of the $1.3bn from Argentina. Even if Kirchner defaults, Singer's firms also hold credit default swaps a type of insurance that will then rocket in value.
