More on Argentina and the Vulture Funds and the sanctity of contracts

So the Argentine government decided to negotiate with the Vulture Funds to avoid a default, which is eminent if no agreement is reached, well, basically today. This is not necessarily bad news, given the potential consequences of a default. It is also one of the frustrating results of the decision of the very Conservative (and pro-bussiness) Roberts Supreme Court. To preside over the negotiations Judge Griesa chose a Wall Street lawyer (who boasts in his CV to have sued Elliot Spitzer for exceeding his authority in investigating Wall Street fraudsters). Argentina is trying to pay today to the ones that renegotiated, but whether that will happen is still not clear (apparently without success).

Note that the consequences of the default could be dire indeed. It would put more pressure on the exchange rate, lead to further depreciation that would be both inflationary, and contractionary, since it would basically reduce real wages. The economy would be forced to continue to grow at very low levels, as it has done since 2011, to avoid a current account crisis. In part, the problem exists even if Argentina does NOT default. Meaning the current account is already close to its limit and the reserves are not sufficiently high (around US$ 28 billions or so), and that's the reason the government has tried to finish negotiations with creditors that did not enter the previous debt reschedulings, including the Paris Club.

The notion is, arguably, that in a world with significant amounts of liquidity, and the chance that low rates of interest in international markets will continue for a while, access to international financial markets would be a reasonable solution for the Argentinean current account constraint. In fact, Brazil has financed a larger current account deficit with little or no problem (maybe the rate of interest is too high, and could be lower, but that's another discussion).

This does not necessarily mean that the Kirchner government has backtracked on previous policies, at least not completely. Reducing foreign indebtedness, after the default and the renegotiation, was the rational choice, and the commodity boom basically provided the policy space for it and for the accumulation of reserves. But borrowing in international markets, when the current account and reserves do not allow for continuous growth, might be fine too if borrowing is done on a sustainable basis. In other words, if the Argentinean government manages exports and imports (import substitution here plays a role as much as export promotion) to allow for the service of debt.

Also, renegotiation of debts (and default might be just a phase in a renegotiation process) are common, and do not show that (as some angry and, quite frankly, not very informed readers suggest in comments on posts on the default, not just in this blog) Argentina is a "deadbeat country and nobody should ever lend to them again." Note that defaults are actually quite common in history.

For example, Cipolla (1982) describes the bankruptcy of the banking houses of a developed country associated to the default of a developing and 'deadbeat' country. What countries are these, you ask. England and Italy, and of course England is the deadbeat one. According to Cipolla (1982: pp. 7-8):

“The large companies of the dominant economy (Florence), which operate in the underdeveloped country (England), have a vital interest in securing the local raw material (wool) for the home market. By logic of events they are led to grant increasingly larger credits to the local rulers, on whose benevolence the licenses for the export of raw material ultimately depend. The rulers of the underdeveloped country, however, instead of using the credit to finance productive investment, squander the funds in war expense and are soon forced to declare bankruptcy.”

So in the mid-fourtenth century the banking houses of Bardi and Peruzzi were brought down by the sovereign default in England and, hence, Florence, more accurately than Italy, was hit by the default. And there are several other countries that would now be considered developed (e.g. Germany) that defaulted before, without being excluded forever from financial markets.

Most countries that default do pay eventually, just at a new rate with extended periods. Renegotiations are normal, and the basis for them is the ability to repay, since it would be better for creditors to receive something. Note also, that creditors (as a whole, not an individual creditor per se) seldom make losses, and that is why all countries after a shorter or longer spell come back to international financial markets. The reason is not difficult to understand, since developing countries pay risk premiums well above the safe assets (Treasury bonds), the advantage of holding developing country debt even for a short while is sufficient for compensating default risks. And besides most savvy investors try to get out before the default (or in the case of Vultures, enter afterwards, to buy debt at the bottom, and make a kill in the courts; it is a good business model, if nothing else).

Changing the terms of contracts, which is basically what a default and renegotiation does, is not new and not the privilege of debtors. In fact, when the credit card company sends a "change of terms notice" to their cardholders, increasing fees or directly the interest rate, it is basically renegotiating unilaterally your contracts. So that is a normal market practice, and Argentina is not violating the sanctity of contracts, and is at least trying to honor its debts, as it has done for the last two hundred years.

Finally, beyond Argentina the consequences of the Robert's Court for international financial markets have been well summarized by UNCTAD, namely:

• First, by removing financial incentives for creditors to participate in orderly debt workouts, the rulings will make future debt restructuring even more difficult, in particular for outstanding bonds without a Collective Action Clause, the actual amount of which is unknown but is likely to be large.
• Second, obligating third-party financial institutions to provide information about assets of sovereign borrowers will have a significant impact on the international financial system as it forces financial service institutions to provide confidential information on the sovereign borrower's global financial transactions to facilitate the enforcement of debt contracts for the creditors.
• Third, the ruling will erode sovereign immunity.

In other words, reduces the chances of debt renegotiations, and of sovereign governments to manage its international reserves, reducing policy space. The question here is not if or whether Argentina should pay, which it was already doing, but at what cost, and who would benefit. The Robert's Court went with Wall Street, and that's no surprise. Interestingly this might hurt even Wall Street. Oh well.

Reference:
Cipolla, C. (1982), The Monetary Policy of Fourteenth-Century Florence. Berkeley: University of California Press.

The Paris Club, Vulture Funds and global debt restructuring

Argentina has finalized a deal with the Paris Club two weeks ago. And tomorrow, if I'm not wrong, the case against the Vulture Funds will be finally decided by the Supreme Court. On the first one, Argentina signed an agreement with the Paris Club that implies the country will pay around US$9.7 billions in the next 5 years.

There is an interesting twist in the agreement with the Paris Club. The agreement was reached without accepting an IMF program, which have traditionally been part of all such negotiations. The Club and the IMF used to be joined at the hip. Two Paris Club chairmen, Jacques de Larosière and Michel Camdessus, became later managing directors of the IMF. So in a sense, the idea was that austerity at home was essential for repayment abroad. Here it is important to note a traditional confusion in the conventional view about the role of austerity.

Note that fiscal austerity can only have an indirect impact on repayment of a debt in foreign currency. You don't need more revenue in pesos (from taxes) to pay interest on foreign denominated bonds, but external revenue from exports, or capital inflows, or accumulated reserves. So austerity helps if it leads to reduced demand for imported goods and services, and more dollars left for repayment.

In all fairness, not having an IMF program is good, but it is NOT a sufficient condition to guarantee that austerity measures will be discarded altogether. I had discussed this before here, but it is far from clear that the Argentinean government will continue to promote a fiscal strategy associated with expansion, which more or less characterized the 2003-2008 boom, and the fast recovery from the 2009 crisis. And while the agreement is also good from the point of view of closing the mess caused by the 2002 default, the problem will not be completely resolved until the Vulture Fund issue is sorted out.

The dangers associated with the Supreme Court's decision are difficult to exaggerate. The Supreme Court may lead Argentina to a new default, not so much because the country can't pay, but because it will not pay (correctly so, in my view). At any rate, worth remembering that creditors have a Club and negotiate from a position of strength, while debtors negotiate one at a time, without the force of collective power. Perhaps the time has come for a Club of Debtors; the Club of Athens might be an appropriate name.