Argentina and the Global Debt Game

What lessons can Argentina teach the players of the borrowing and lending game?

December 24, 2001

What lessons can Argentina teach the players of the borrowing and lending game?

The riots and resignation of the de la Rúa government this week in Argentina make it almost certain that the government, after a long struggle, will now default on its 132 billion U.S. dollar-denominated sovereign debt.

It was always hard to imagine how a nation’s bankruptcy mechanism could be negotiated within the IMF, which contains 20 executive board directors representing a varied group of interests. Now, this mechanism is likely to be negotiated in real time in a real market place.

The incredible fact in all this is not Argentina’s imminent default. Rather, it is that at least $60 billion of Argentine government bonds were purchased and held over the last decade by otherwise perfectly sane managers of foreign mutual funds, pension funds, insurance companies, private trusts and wealthy individuals.

Another $30 billion in Argentine debt is held by foreign governments and international agencies such as the World Bank and International Monetary Fund.

These official loans were advanced mostly since 1997 to bankroll President de la Rúa’s efforts to modernize government, privatize industry, abandon protectionism — and shrink the lavish social handouts that have dragged Argentina into poverty.

The riots have — temporarily at least — blown these feeble reforms to the wind. And foreign investors, private and official, are left holding an empty bag.

Given Argentina’s protracted history of social self-indulgence and profligacy, the real question is why the Argentine government was able to sell dollar- denominated bonds to any foreigners in the first place.

It is not as if Latin America’s third-largest country could be mistaken for a Britain or a France. But then, colossal failures of analysis and emotional instability of investors are no rarity in free markets.

The bankruptcy earlier this month of high-flying giant Enron Corp. of Texas is another glaring example. Enron went from an investor’s darling to total nightmare — in all but six tumultuous months.

But the Argentine case does involve several unique and obvious failures. The country’s crash, after three years of increasing support from the IMF under a conventional stabilization program, is going to alter the very way the IMF and world finance do business in the future.

The first unique aspect of the Argentine crash is that lending to developing countries had long before been proven a formula for disaster. Look at the record.

The world’s commercial banks clearly demonstrated, from 1980 to 1997, that most developing governments lack the long-term political, social and financial stability — and, simple honesty — to carry substantial amounts of net debt to foreign lenders.

After problems in the late 1980s in Russia and Eastern Europe and in Asia in the late 1990s, now comes Argentina.

After decades of hyperinflation and sagging living standards, Argentina adopted a stunning currency reform in the 1990s. It established a currency board, backing a newly issued peso, one for one, with U.S. dollars — and offering to swap the two currencies back and forth at any time.

The world’s bond buyers took the currency pledge as a proxy for total reform. Never mind that Argentina had only started on the reform of its state ownership, protectionist trade policies and unfinanceable jobs, health and pension promises.

American and European banks brokered the bond sales for fat commissions. But rather cynically, they bought almost none of these fine new Argentine treasuries themselves.

Instead, their foreign money managers eagerly snapped up the Argentina issues. This was partly due to the fact that they yielded 25 percent to 50 percent more interest than U.S. Treasuries. These money managers were thus hoping for good returns on their investment.

International investors imagined a second reason to buy too. As opposed to bank loans, they felt that a sovereign country like Argentina would never even temporarily default on its debt bonds. They thought so principally for two reasons.

The first was that the World Bank, the International Monetary Fund and such giant countries as the United States and Germany have always partly or fully rescued even bank lending to troubled countries. Surely, they’d rescue bond buyers, if only the consequences of default on bonds are likely to be more terrible than default on loans from banks.

Second, banks represent a single class of professional lenders who can and do routinely form a committee that negotiates a basically smooth — if slow — restructuring with the defaulted country. Although impaired, the country’s business with the rest of the world is carried on during the negotiations, supported with additional credits from the good old IMF.

In the case of bonds, however, there are literally thousands of different investors, ranging from mutual funds to private trusts to individuals. And they are spread out all over the world. Forming a committee to represent these disparate interests has always been deemed impossible. Thus, bond lenders in one of Mexico’s defaults were eventually bailed out entirely — partly by the banks, partly by the IMF.

Foreign money managers snapped up the Argentina issues — partly because even at first they were advertised to yield 25 percent to 50 percent more interest than U.S. Treasuries.

Armed with these reassuring thoughts, foreign investors were always eager to buy Argentina’s bonds. The Argentine government, for its part, found it easy to finance continued profligacy with its foreign borrowings and slowed the pace of its reforms.

Three years ago, Argentina’s trade accounts and budget once again plunged heavily into the red. The IMF did arrive promptly to stage a rescue. But this time, the sums owed by Argentina were so large — and Argentina’s real problems so persistent — that the rescue has not worked.

This week, the Argentines rioted and overturned their government rather than accept new austerity and new reforms. Spokesmen for the Peronista Party, which will likely take power from the reformers, were talking openly of bond default, abandonment of free markets, and a return to protectionism, higher taxes as well as increased pensions and other burdens.

Such policies have turned Argentina from the second- richest country in the world in 1929 to a poor one in 1990. But given their 60 years of popularity, no one should be shocked that the Argentines perversely yearn for, or at least accept, their return.

There have been earlier small temporary bond bankruptcies — Russia in 1998 defaulted briefly on $5 billion in foreign bonds. But Argentina’s de facto bankruptcy is a “biggie.” It will plunge Argentina at least briefly into political and economic chaos and will force international authorities into a frenzy of improvisation.

Whatever else happens, the IMF and the U.S. Treasury are going to have to improvise the first formal bond bankruptcy procedure for a sovereign nation in post-war history. U.S. Treasury Secretary Paul O’Neill and other U.S. conservatives have been pushing for such a mechanism to be operated by the International Monetary Fund anyway.

Basically, the mechanism would be the equivalent of bankruptcy procedures that exists for handling restructurings of troubled private corporations in all developed nations. They will enable a country debtor — in this case Argentina — to impose a substantial write-off on the face value and interest rate on its bonds while retaining enough credit worthiness to maintain the import and export of its basic needs. In exchange for real reforms, the IMF might then guarantee the reduced level of debt.

From the point of view of Mr. O’Neill and other reformers, this reform is long overdue. For the first time, private- sector foreign lenders to developing countries would face, up front, the prospect of genuine deep losses on their loans. This more would place real risk back into a credit picture that now lets lenders earn higher yields than on safer big-country investments. But it would shuffle the risk away from the IMF and other public sector institutions when the loans go bad.

One way or another, authorities will have to devise some sort of arrangement for dealing with holders of Argentina’s defaulted bonds, while Argentina itself somehow survives economically as it abandons reforms and returns to its Peronista roots.

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