Download Argentina: The Default before the Storm

Date of Commentary: 28 August 2014
Argentina: The Default before the Storm
Commentary Highlights
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Litigation in U.S. courts has led to a default on Argentina’s exchange bonds. Some
bondholders may eventually accept a new government offer to swap their exchange bonds
into new securities issued under Argentine legislation, but Argentina is likely to remain in
default on the exchange bonds for an extended period.
Against the backdrop of Argentina’s growing macroeconomic imbalances, a prolonged
default could have highly adverse implications for consumer and investor confidence, the
pace of capital flight, and central bank efforts to reduce inflation.
Regardless of whether the default is remedied quickly or not, failure to adjust fiscal and
monetary policies may undermine macroeconomic stability and result in a much deeper
crisis.
Attempting to cure a default, a U.S. court ruling leads to another default
A U.S. court ruling has forced Argentina to choose between defaulting on bonds issued in its 2005
and 2010 debt exchanges, and paying off the creditors that refused to participate in those same debt
exchanges. 1 Argentina, in spite of the potentially high cost of default, has refused to negotiate a
settlement with the holdout creditors. As a result, exchange bondholders have not received their
interest payments. Efforts to work around U.S. courts – and by extension, the U.S. financial system
– are unlikely to resolve the default quickly and could impose high costs on the Argentine economy.
The Argentine government will eventually need to resolve its long-running dispute with holdout
creditors, but prospects for a deal before 2016 remain dim.
In mid-June 2014, the U.S. Supreme Court declined to hear Argentina’s appeal in NML Limited v.
Republic of Argentina. With the appeals process exhausted, the U.S. Court of Appeals shortly
thereafter lifted the stay on the New York District Court’s amended February 2012 orders. The
ruling instructs Argentina to make pro rata payments to holdout creditors when it makes payments
on its performing exchange bonds, and prevents the trustee for Argentina’s exchange bonds, Bank
of New York-Mellon, from transmitting any payments to holders of these exchange bonds
(exchange bondholders) unless Argentina complies with the ruling. 2
Despite the court orders, Argentina transmitted a $539 million interest payment on the exchange
bonds to the Bank of New York before the June 30 due date. Discussions with holdout creditors
continued through July, but the failure to settle the legal dispute before the expiry of the 30 day
grace period prevented the Bank of New York from transmitting the payment to exchange
bondholders. Accordingly, DBRS deemed that Argentina was in default, and downgraded
Argentina’s credit rating to selective default (SD) on July 31. Thus far, Argentina’s default remains
1
Argentina defaulted on its debt in December 2001. In 2005, the government launched a debt exchange, offering a range of new securities
(the exchange bonds) to the holders of some $82 billion in defaulted bonds. The exchange was reopened in 2010, and a cumulative 92%
of the defaulted bonds were tendered in the two exchanges. Many of the holders of the remaining $6.4 billion in defaulted bonds (holdout
creditors), who were not necessarily holders of the bonds at the time of the exchanges, have sued Argentina in foreign courts, seeking
full repayment or at least a substantially improved restructuring offer. NML Limited is one of the holdout creditors that has sued in U.S.
courts.
2
The exchange bonds affected by the court ruling include the 2033 discount bonds, the 2038 par bonds, and the 2017 global bonds.
Argentina’s exchange offer also included a GDP warrant (maturing in 2035), but no payments are expected on the warrant until
December 2016 at the earliest.
Sovereign Ratings Group
Commentary 1
Date of Commentary: 28 August 2014
a technical one, specific to the exchange bonds issued under foreign legislation, and unrelated to
the country’s capacity to pay.
Argentina remains steadfast in its refusal to negotiate any settlement with holdout creditors that
would be more favorable than the settlement accepted by participants in the 2005 and 2010 bond
exchanges. Argentine authorities continue to assert that the ruling is unfair, and have called the
New York court’s actions a violation of Argentine sovereignty. In addition, the government
maintains that it has met its obligations on the exchange bonds and that its actions cannot be
construed as a default. A clause in Argentina’s bond contracts that grants exchange bondholders
the right to benefit from any future offer to holdout creditors (the Rights under Future Offers, or
RUFO clause) expires on December 31, 2014. It is possible that the authorities could change their
stance on negotiating with holdout creditors after this date, although the expiration of this clause
alone is unlikely to change the government’s long-held position.
Government authorities are presently moving forward with a new debt exchange announced by
President Fernandez de Kirchner on August 19. Argentina plans to allow exchange bondholders to
swap their restructured claims for new securities issued under Argentine law and with the same
payment terms. The new securities would, in theory, enable Argentina to make payments through
the Argentine central bank (BCRA) and avoid the use of U.S. financial intermediaries.
These actions are unlikely to quickly resolve the default, given that some investors will be unwilling
or unable to hold bonds issued under Argentine law. The New York Southern District Court, which
had specifically proscribed such actions by Argentina, has called the swap “illegal” and this may
deter investors from participating in the exchange. In addition, the exchange will be difficult to
execute without the cooperation of the trustee, which is bound by the ruling to avoid facilitating
such an action. Over time, the government may be successful in arranging for some of the exchange
bondholders to be paid in Argentina. There is likely to be a new group of holdouts from this new
exchange, however, and Argentina is likely to face additional litigation until a comprehensive
settlement can be reached.
The main consequence of Argentina’s default is to delay its eventual reentry into global bond
markets. Subnational governments and Argentine companies are likely to also pay a significantly
higher price for bond issuance. While the government has financed itself entirely in the domestic
market for over a decade, Argentina now faces growing economic and fiscal pressures. In addition,
presidential elections will occur in October 2015, and major policy adjustments may be difficult to
implement until a new government is in place.
Significant economic pressures, regardless of default
Argentina has been in recession since the fourth quarter of 2013, and recent developments suggest
the downturn is likely to continue through the remainder of 2014. The recession is directly tied to
inconsistent macroeconomic policies and the lack of price stability, compounded by declining
commodity prices and weak growth in major trading partners. The government has rapidly
increased public spending over the past several years, while putting pressure on the BCRA to
maintain low interest rates and finance government deficits. This policy mix has been a key
contributor to high inflation, now running at over 40%. Negative real interest rates discourage
residents from saving in pesos, and encourage the purchase of dollars, real estate or other real assets.
Consequently, efforts to prop up domestic demand through monetary or fiscal stimulus are likely
to instead result in higher inflation, capital flight and a loss of reserves.
Sovereign Ratings Group
Commentary 2
Date of Commentary: 28 August 2014
The government has nonetheless continued to favor large public spending increases, with annual
growth in current expenditure running at 50% in the first half of the year. In contrast, current
revenue excluding property income has grown only 35% in nominal terms. This divergence has in
turn led the government to increase its reliance on property income and borrowing from the social
security fund and from the BCRA. Even with property income, the primary balance has deteriorated
from 3.2% of GDP in 2008 to -0.8% of GDP in 2013. Fiscal results from the first half of 2014
suggest the trend is worsening.
Realizing property income from the social security fund and BCRA, in addition to direct borrowing
from the BCRA, injects additional pesos into the Argentine economy. From December 2009
through December 2013, the expansion of Argentina’s money base averaged over 30% annually.
Over the same period, BCRA claims on the central government increased over 500% in local
currency terms. Property income reached an annualized 2.4% of GDP in the first half of 2014, 58%
of which came from the BCRA. This large scale money creation has significant consequences for
inflation, particularly given the limited role of credit in the economy. High inflation, unless offset
by currency depreciation, increases demand for imports, worsening Argentina’s trade balance.
Furthermore, because domestic interest rates have not risen to counter high inflation, domestic
residents resort to saving in foreign currency, placing additional pressures on foreign exchange
reserves.
In response to the external pressures, in January 2014 the new head of the BCRA allowed the peso
to depreciate and engineered a substantial increase in interest rates. The BCRA’s efforts have been
partially successful in curbing inflationary pressures and stemming reserve losses. Reserves
increased by $2 billion in the second quarter. Although headline inflation has soared to over 40%
due to the devaluation and the impact of utility price hikes, demand pressures have eased and
median inflation expectations have remained stable. BCRA absorption of the excess money
creation resulting from deficit spending has increased markedly. The increase in net BCRA claims
on the government since end-2013 can be explained almost entirely by the devaluation, and the
pace of monetary base growth has fallen to 18.6% as of end-July, down from 28.4% in July 2013.
Policy options are limited, particularly in the context of default
Given the lack of support from fiscal policy, the BCRA’s efforts have not yet been sufficient to
materially reduce inflation expectations. Meanwhile, the BCRA and the broader banking system
remain under pressure to reduce interest rates and increase the flow of credit to the real economy.
Unless the government is willing to bear the near term political cost of high interest rates and
reduced government spending, Argentina will likely experience renewed exchange rate pressures
and reserve losses. Indeed, the official exchange rate has again come under pressure in recent days,
weakening to over 8.40 pesos per dollar in spite of increased sales of foreign exchange reserves by
the BCRA.
Argentina is not likely to experience a durable recovery until inflation is brought under control. A
lengthy period of positive real interest rates would be necessary to increase confidence in the peso
and encourage domestic savings. A gradual fiscal adjustment would also be needed to curb
expenditure growth and reduce the government’s reliance on monetization. Given the current state
of the economy, fiscal and monetary tightening would come at a price, reducing employment and
economic growth in the short-term, in exchange for a restoration of confidence in price stability
over the medium-term.
Sovereign Ratings Group
Commentary 3
Date of Commentary: 28 August 2014
Resolving the default could open up increased external borrowing. By doing so, government
authorities would likely be in a position to undertake a more gradual policy adjustment. The positive
effects on confidence and the increased capacity to borrow externally could provide a considerable
boost to reserves and ease fears of further currency depreciation. Investment would likely increase,
especially in the energy sector. On the other hand, absent a settlement with the holdouts, the
government will likely need to pay higher domestic interest rates to attract private financing, and
accelerate the pace of fiscal adjustment.
Regardless, with elections only 14 months away, the authorities appear to be unwilling to take this
approach. A more likely alternative is a continuation of heterodox policies, including price and
import controls, periodic currency depreciations, and attempts to stimulate economic activity by
directing public spending and credit to specific sectors. However, the marginal benefits associated
with these policies can be expected to continue to decline: price controls are leading to shortages,
import controls to production shutdowns, depreciation to inflation, and public spending and credit
to capital flight. A continuation of these policies is likely to only postpone the needed adjustment
and raise the risk of an inflationary spiral, a collapse of the peso, and a deeper recession.
Sovereign Ratings Group
Commentary 4
Date of Commentary: 28 August 2014
Thomas R. Torgerson
Vice President
Sovereign Ratings Group
Tel. +1 212 806 3218
[email protected]
Michael Heydt
Vice President
Sovereign Ratings Group
Tel. +1 212 806 3210
[email protected]
Fergus J. McCormick
Head of Sovereign Ratings
Senior Vice President
Tel. +1 212 806 3211
[email protected]
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Commentary 5