Some things do change. For the first time in a long time, Argentina is paying its international bonds. It completed its bond exchange last week, delivered the new bonds to its investors, and made the first coupon payment.
A few holdout creditors challenged the exchange in court, but their complaints were dismissed. The exchange went ahead.
Argentina’s legal troubles are not over. Creditors who stayed out of the exchange will try to find a way to stop the payments on the new bonds, arguing that it is illegal for Argentina to pay its restructured debt (the "new" bonds) while still in default on its "old" bonds. That is likely to be an uphill battle. But you never know.
More importantly, a large number of retail investors did not go into the deal -- particularly Italian retail investors. That will complicate Argentina’s life for a long time. Argentina may be able to ignore the Darts (a well known holdout creditor) but it cannot entirely ignore the government of Italy. At some point, Argentina will need to reopen the exchange and give the holdouts a chance to come in (maybe at a discount to penalize them for staying out initially, maybe not).
This seems as good an occasion as any to note that I have posted a paper that I wrote with Anna Gelpern on the RGE web page (Anna is a rising star of the sovereign debt legal world). Our paper was written well before Argentina concluded its exchange -- but the broad outlines of a deal were still pretty clear a year ago. The focus of the paper, though, is not on the relative treatment of domestic and external sovereign debt during a severe financial crisis.
The argument that the paper makes -- international debt is unlikely to be treated the same as domestic debt in a sovereign debt restructuring -- probably won’t endear either of us to some.
With the advent of globalization, domestic and foreign investors can and do buy the same debt instruments. But this does not mean that their political and economic interests have converged, or that they have the same political and economic leverage with the government. It should come as no surprise then that the two groups rarely get equal treatment at the hands of a government that has run out of money.
But I suspect the smart money in emerging markets understands this reality already.
Legally, international bondholders don’t have the capacity to block domestic payments. Argentina has been paying its domestic peso debt for the past three years, but not -- at least until this past week -- its international bonds. Argentina also showed us that even if domestic and international investors both hold international bonds prior to default, nothing prevents a country from convincing its domestic investors to swap their bonds for something different, and then treating that "something different" held by domestic investors better.
The legal composition of a sovereign’s debt is increasingly fluid, as targeted debt exchanges can quickly transform the country’s debt. In a crisis, such exchanges can help the sovereign segment its creditors into different groups, making it easier to treat each group differently. Ex-ante risk management must reflect this new, dynamic and flexible character of sovereign borrowing. For example, it would be a mistake to assume that all of a sovereign’s foreign-law debt will be treated alike in distress. The effective status of a single obligation relative to others could change several times in its lifetime as the sovereign dilutes, elevates, and subordinates instruments to suit.
Economically, it is not clear that a country should treat domestic and international debt the same, particularly if the domestic debt is held by the domestic banking system. Nor is it clear that the trade off between domestic pain now (writing off domestic debt) and domestic pain later (paying off domestic debt with higher future taxes, less future spending) really determines the recovery rate on defaulted external bonds. What ultimately determines the recovery rate for international debt is the primary surplus (And trade surplus) that the country is willing to devote to external debt service -- not the treatment of its domestic debt. More domestic pain, say big losses for bank depositors, now may generate a pretty strong domestic political consensus to impose more pain on external creditors, not free up resources for external debt service. Politically, citizens vote and international bondholders don’t. A sovereign’s capacity to give priority to debt held by the countries citizens is one of the few ways a country in default can try to limit the domestic "pain" that usually accompanies default.
Anna and I can be accused of over-generalizing based on the example of Argentina, but I am pretty confident that our basis conclusion -- that domestic and foreign investors are unlikely to be treated in exactly the same way in a crisis -- will prove to be pretty robust.