By John Weeks

Back Story

On 30 July the Argentine government found itself in default on its external debt.  If you read my previous article on this singular “default”, you know that just over ten years ago the newly-elected president of Argentina, Néstor Kirchner, rejected responsibility for the external debts his predecessors had so recklessly accumulated.

The specific form of this feckless misbehavior had been the attempt by the neoliberal regimes of the 1990s to sustain the Argentine peso one-to-one with the dollar.  To paraphrase Oscar Wilde’s comment on fox hunting, this was a case of the unspeakable in pursuit of the unsustainable.  Many of the Great-and-Good (e.g., Joseph Stiglitz winner of the Bank of Sweden’s faux Nobel Prize) have weighed in on the side of the Argentine government.  Few if any point out that the accumulated indebtedness brought not a cent (centavo) to any Argentine who was not a currency speculator.

Nestor Kirchner, President of Argentina, 2003-2007. Thumbs up to Argentina, down to MNL Capital.  Source here.

The new Argentine government of Kirchner negotiated with creditors over the amount they would repay of the $80 billion debt.  Such renegotiations of debt occur quite commonly among creditors and debtors, both public and private (e.g., when corporations declare bankruptcy).  After several years agreement was reached with creditors holding over 90% of the debt to accept 30% repayment (to employ the current cliché, the creditors accepted a “hair cut”).

As these discussions proceeded some hedge funds saw the possibility of making a fast buck (to use an old fashioned cliché) by pursing Argentine debt with the intent to hold out for full payment.  Foremost among these debt speculators was MNL Capital that had bought its $1.3 billion (face value) of bonds at far less than that, and far less than the 30% reached in the agreement, how much less we do not know because MNL Capital has not been notably forthcoming with such information (their website is a blank page with a small logo and nothing more).

To achieve their speculative end, the directors at MNL Capital “went to court” in New York state, where some of the Argentine bonds were sold (establishing jurisdiction for the case, NML Capital vs. Argentina).  To the surprise of many if not most, the judge ruled in favor of MML Capital, and the US Supreme Court declined to review the case (de facto endorsing the lower court decision).

What makes this lender-borrower dispute rather unique is that the cash to meet the pending debt obligation (less than $600 million) sits in the Bank of New York Mellon ready for collection by the holders of the 90% of the debt that was renegotiated.  The funds remain frozen in the Mellon bank because the judge in the case ruled that the Argentine government could pay no creditor without also paying the “holdouts” — the speculators in MNL Capital;  ergo, we have default by the formal definition.

This is the first case I have ever encountered in which the borrower has made the necessary debt service payment, but the lender is prohibited from collecting it.  Even the International Monetary Fund, always in favor of full payments of sovereign debts, described itself as “deeply concerned about the broad systemic implications” of NML Capital v Argentina, with a stronger criticism of the court decision made by Alicia Bárcena, head of the United Nations Economic Commission for Latin America and the Caribbean (CEPAL in Spanish).

The IMF’s concern is hardly surprising because if the New York court decision becomes generally accepted legal practice, many countries face financial disaster now or in the future.  This disaster does not immediately threatened or even focus on Argentina.  The danger lies in the longer term implications for sovereign debt management.

But, first, the impact on Argentina:  according to the Guardian “it could add more pain for Argentinians [sic! Argentineans], with the economy already in recession”.   It would appear that most bond speculators disagree.  As reported a few days ago in the Financial Times, Argentine bond prices have risen, not fallen, after the formal default last Wednesday (“Argentina bondholders focus on hope over experience“).

The explanation for the bonds selling at 89¢ on the dollar — the highest level in three years — should be obvious.  The Argentine government wishes to pay the service on 90% of its debt, but is prevented from doing so by a court order.  Any compos mentis speculator (aka “investor”) draws the obvious conclusion — the government is willing and financially able to service its debt (check out another FT article).

Should an Argentine government wish to borrow in global financial markets — which none has done for a decade and a half — it could do so at non-prohibitive interest rates.  The point is mute because the current government is unlikely to do so.  While the latest statistics show large deficit on the current account (trade, services and short term money flows such as profit remittances), the government holds foreign currency reserves almost ten times the deficit).

The limited impact of the formal debt default does not mean that all is well with the Argentine economy.  Depending on your definition of “recession”, Argentina is either in it or on the way.  Whether it is or it is not, the debt issue is not the major factor.  It is no great secret that the Argentine economy rises and falls with the fortunes of its much larger neighbor, Brazil (the former economy about $500 billion, the later $2.3 trillion).

As the chart below shows, after following the Brazilian economy up for 4 quarters, in mid-2013 the Argentine growth rate fell with Brazil’s, over-shooting in both the up-swing and the down-swing.  The economic problem that dominates the headlines in Argentina, inflation, has little to do with tension over the external debt (the economy has been prone to inflation, even the hyper version, for decades).

Follow the Leader: Annualized quarterly growth rates for Argentina and Brazil

(each quarter compared to the same quarter of previous year)

Data from OECD.

The real losers from the off-the-wall court decision undermining the renegotiation of Argentina’s external debt are poor countries, especially in Africa.  Unlike Argentina with its by-comparison diversified economy and skilled labor force, the countries of the sub-Saharan region have few options.  Their underdeveloped financial sectors and near-total dependence on primary product exports leave them heavily reliant on foreign borrowing.  As catalogued by Daniel Huang in the Wall Street Journal several sub-Saharan countries have suffered assaults by hedge funds. For the poor countries of the earth it could be the difference between stagnation and development.

“Let us prey”, from Thomas Nash, 19th century US political cartoonist. Provided by http://www.greatcaricatures.com/.

There is a general principle in the affairs of finance — default by a small borrower is the debtor’s problem and default by a large borrower is the lender’s problem.  During the Latin American debt crisis of the 1980s that principle was over-ruled by the US government, which prevented defaults by a variety of political and economic interventions.

The US government now lacks the power to do that again, and the rule is back in force.  A global mechanism for sovereign default would make life easier for countries such as Argentina.  For the poor countries of the earth it could be the difference between stagnation and development.

“The Rake in a Debtors’ Prison” from William Hogarth, 1735.

A solution to sovereign debt default?