July 29, 2014

Argentina's Default Will Have Wide Implications
Argentina is probably going to default tomorrow. An Argentinian debt default would clearly not be good for the country economically, but contagion would probably be limited and far less hard hitting than its previous 2001 default. If Argentina does default tomorrow, the biggest casualty would be the process of sovereign debt restructuring, which would become chaotic and haphazard.

How Argentina Made it to the Brink
Argentina has one more day to make an interest payment to bondholders before it officially defaults. The government is perfectly willing and able to pay these bondholders, which agreed to participate in debt restructurings after Argentina defaulted in 2001. On June 30th, the Argentinian government deposited $1 billion with Bank of New York Mellon Corp to show that Argentina has pledged the money to comply with its obligations to its creditors.

The problem lies with Argentina's holdout creditors, which have refused to participate in the debt restructuring, and picked up Argentinian sovereign debt at a huge discount in the hopes that they would eventually be made whole. In a trial held in the New York Federal court brought against Argentina by some of these holdouts, Judge Thomas Griesa ruled that Argentina cannot pay the restructured bondholders unless it pays the holdouts too. The case was heard in US courts because the bonds are under US law. Judge Griesa made this ruling because of a pari passu clause in the original bond agreements, saying that they must be equal in right of payment with all other Argentine bonds. As a result, that money deposited with Bank of New York Mellon Corp is not allowed to be passed on to the restructured bondholders unless Argentina pays the holdouts at the same time. According to some estimates, Argentina would owe the holdouts up to $16 billion in principle and unpaid interest.

Argentina has insisted that it cannot pay the holdouts, having only around $30 billion in foreign reserves. Argentina also claims that it cannot strike a deal with the holdouts because of the Rights Upon Future Offers (RUFO) clause in its restructured bonds. According to the RUFO clause, the Argentinian government promises that if it is able to negotiate more favorable terms with the holdouts, the restructured bondholders would get the same deal.

Why Argentina Looks Set to Jump off the Cliff
Is default the best option for Argentina? Maybe. Last time the country defaulted in 2001, the country was thrust into depression, hyperinflation and social unrest. However Argentina is currently facing a different kind of default; Argentina has both the ability and the desire to make its interest payments on the restructured bonds and avoid default—it just isn't allowed to without paying the holdouts too because of a ruling in American courts.

One option for Argentina would be to default on its restructured bonds, offer to swap those bonds for new ones under Argentine law and—free of US court rulings—go on servicing them. Participation in this kind of bond exchange should be high since Argentina will have already defaulted, and so the potential alternative for creditors would be to get nothing. The great difficulty for countries that have undergone sovereign default is rebuilding their credibility in the markets so they might be able to borrow again. Under this kind of bond exchange, those participating would be getting paid as promised, so Argentina would hardly lose credibility.

That would leave the holdouts to deal with. Right now, the holdouts' biggest source of leverage with Argentina is that they can—with the help of US courts—prevent Argentina from paying its restructured bondholders and force a sovereign default. If Argentina goes ahead and defaults, that leverage no longer holds any sway. The holdouts can continue to drag Argentina through the US courts to try to get their money back, but it would likely take decades.

Another option for Argentina is to default and then settle with the holdouts. It is very likely that the holdouts hold some credit default swaps (CDS)—insurance against default—on Argentina's bonds. If this is the case, a default would trigger a CDS payout. Argentina could then agree to pay the difference between what it originally owed and what the holdouts made on the CDS payout.

Wider implications
A default tomorrow, of course, would not be entirely painless. Some economists believe another Argentine default would do significant harm to the country's reputation, with borrowing costs soaring. The gloomiest economists expect a default would push Argentina further into recession, cause inflation to accelerate and induce capital flight.

Whatever the implications for Argentina, a default would have much wider implications for the process of sovereign debt restructuring . The US's court ruling on the pari passu clause on Argentinian bonds gives the holdouts of any bonds under US law a channel to seek payment if restructured bonds have been serviced. It also means there will be very little incentive for bondholders to participate in bond exchanges for debt under US law. Furthermore, the US may have just set a precedent for ruling on pari passu clauses, in which case all foreign law bond restructurings will be affected. Sovereign debt restructurings will become more chaotic and litigious, a worrying development in a global environment characterized by unsustainable public debts.

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