Has Argentina changed the rules of the sovereign debt game?

Argentina is on the verge of completing one of the largest sovereign debt restructurings in history. Argentina is seeking to restructure about $82 billion in bonds, plus $21 billion or so in past due interest. The biggest preceding bond restructurings were Ecuador ($6.5 billion) and Uruguay ($4 billion of international bonds) -- so Argentina’s restructuring is absolutely massive. It dwarfs Russia’s 2000 restructuring of about $30 billion in international sovereign debt. (technically, Russia restructured syndicated bank loans, not bonds, but since lots of the loans had been sold into the market, the difference between bank loans and bonds was bit blurred).

Investors had until Friday to tender their bonds in the exchange. The final results will be announced next week. Recent estimates suggest that 75%, maybe more, of all eligible debt participated in the exchange.

Investors who participate in the exchange are giving up their legal right to full payment of principal and all past due interest. But since the legal right to full payment is nearly impossible to enforce, investors effectively are giving up an old bond that won’t be paid for a new bond that Argentina should pay. The catch? Argentina offered a maximum of $42 billion in new bonds in exchange for roughly $82 billion in old bonds. Or, to think of it a bit differently, the market value of the old bonds was about $26 billion ($82 billion face worth roughly 32 cents on the dollar). If all holders of old bonds swap into new bonds, the new bonds will also be worth about $26 billion ($42 billion face, and an average price of 62 cents on the dollar), and probably a bit more if there is a post-restructuring rally. So investors are recovering only a bit more than 30 cents on their original dollar, assuming they initially bought the bonds at par.

Argentina, consequently, is about to carry off not just a big restructuring, but also to get substantially more relief from its creditors than debtors have gotten in previous debt restructurings -- something that Argentina’s President, Nestor Kirchner, never hesitates to point out.

Kirchner clearly thinks the deal is a good thing for him.

But is it a good thing, or a bad thing, for the broader international financial system?Some -- and not just creditors with skin in the game -- argue that Argentina’s exchange is nothing more than a mugging of creditors. Walter Molano, quoted in this Reuters story, is typical of those who worry that Argentina is setting a terrible precedent:

"There are a host of countries waiting in the wings to see what happens with the Argentine restructuring, before deciding how to proceed," wrote Walter Molano.

According to this argument, by letting Argentina get away with this exchange, the IMF and the G-7 are undermining the sovereign debt market.

Of course, the creditors who opted to participate in the exchange are at least as responsible for the outcome as the IMF and the G-7 (Argentina has not exactly been following all of the IMF’s advice for the past few years). It is interesting that private creditors, who often argued that the IMF should stay out of sovereign debt restructurings, have been desperate to get the IMF to weigh in on their side over the past few weeks. The creditors discovered that they had far less leverage than they initially thought ...

Others -- and I clearly am in this camp -- say that Argentina sought more debt relief than other debtors because it ended up in a worse position than other debtors after its default. It went into its crisis with substantial debts generally, and an unusually large amount of external sovereign debt in particular. It experienced an unusually deep crisis -- in part because it went through an exchange rate crisis, a sovereign debt crisis, a banking crisis and a corporate crisis all at once.

Argentina’s pre-crisis public debt to GDP ratio of a bit over 50% was a bit deceptive. Argentina’s GDP was valued at a massively overvalued exchange rate before its crisis; at realistic exchange rates, the government’s debt to GDP ratio was more like 80% or even a 100%

Consequently, Argentina needed more debt relief than other debtors. This is not to say Argentina could not have made a slightly more generous offer -- I previously have argued that Argentina should have tried to sweeten its offer by putting a bit more cash on the table. That might have increased participation and reduced Argentina’s future legal troubles without risking its future solvency. But while Argentina had room to adjust its offer at the margins, it could not have made a substantially more generous offer without putting its ability to emerge from its cycle of debt and default at risk.

Even if all creditors agree to Argentina’s proposed terms, its overall debt levels will remain very high. Its debt to GDP ratio will remain around 80%. Servicing that debt will require that Argentina sustain a primary surplus -- revenues in excess of non-interest expenditures -- of around 4% of GDP.

Overall debt levels don’t tell the entire the story. There is a difference between the debt a sovereign government owes to its own people, and the debt it owes to external creditors. Defaulting on domestic debt is defaulting on yourself -- it reduces domestic wealth, and usually devastates the domestic banking system. That is hardly a recipe for domestic political success. Countries with large amounts of domestic debt -- notably Brazil and Turkey -- have made major fiscal adjustments to avoid a domestic default.

High levels of external sovereign debt are another thing. External debt implies an ongoing net transfer out of the country: sustaining the political support for that transfer in the face of adverse shocks is hard. According to JP Morgan data, Argentina’s "external sovereign debt to GDP ratio" will remain unusually high even after its restructuring, at 50% of Argentina’s current GDP. That ratio is comparable to countries like Ecuador (35% of GDP) and Pakistan (49% of GDP). It is well above the levels of Mexico (12%), Russia (13%) and Brazil (18%).

In my view, high levels of external sovereign debt are sustainable only if the coupon on the debt is low and the debt does not need to be refinanced frequently (as will be case with Argentina), or if the debt is owed to unusually generous creditors, like the Paris Club, who tolerate frequent arrears (see Pakistan) ...

Will Argentina’s restructuring set a bad precedent and undermine the broader market. Paul Blustein says no.

"I just don’t buy the argument that this will set a precedent for Brazil or Turkey or any other country," said Paul Blustein, author of ’And the Money Kept Rolling In (and Out)’, a new book on Argentina’s economic collapse. "This country went through hell," he said. "Any country that thinks this is a good way to reduce your debt burden is nuts."

I tend to agree. More importantly, the evidence suggests that the market also agrees with Blustein.

Argentina’s desire for a major debt relief are hardly a surprise. It has been known for some time. If creditors were really worried that Argentina’s restructuring made default and deep debt relief an attractive option, they would either raise their estimate of the probability an emerging market will default or reduce the amount they expect to recover on a defaulted bond. Both would tend to reduce a bond’s value. What actually has happened? The value of almost all emerging market bonds has gone up over the past two years ... hmm.

Obviously, this has something to do a global surplus of liquidity, which is leading investors to bid up the price of all fixed income assets. But it is more than that too. PIMCO holds more emerging market bonds than anyone I know of, around $20 billion. Even though they were smart enough to get out of Argentina well before it defaulted, they certainly would worry if Argentina’s default and subsequent restructuring radically changed other sovereign government’s incentives to pay.

However, PIMCO looked around the world and did not see emerging markets acting like they wanted to follow in Argentina’s footsteps. Rather, they saw most emerging markets, most notably Brazil, taking steps to enhance their creditworthiness after Argentina’s default. Look at Brazil’s primary surplus, Turkey’s primary surplus, even Ecuador’s primary surplus. Look at the current account surpluses and reserves of most emerging economies, not just Asian economies.

This is not to say that Argentina’s restructuring will have no impact. Argentina did not show that default is painless, but it did show that the costs of external default are heavily frontloaded. Heavily indebted countries that have already incurred the upfront costs of default are likely to look at Argentina’s example and be less inclined to rush to do a quick deal with their creditors. But that does not mean all countries in difficulty will emulate Argentina. Some are likely to emulate Uruguay instead, and seek to restructure their bonds on terms that are (comparatively) favorable to creditors to try to buy the time they need to avoid an Argentine style meltdown.

Argentina does set a precedent. But it is not the only precedent out there, and it is a precedent that most countries won’t find all that appealing.

Be wary of over-generalizing based on a single example.

Russia had the biggest sovereign default and restructuring before Argentine. In 1998, Russia defaulted on its domestic treasury bills -- the famous GKOs. Incidentally, international investors held lots of these treasury bills, so it does not contradict my earlier argument about the importance of looking at the share of debt held externally. It defaulted on Soviet era syndicated bank loans. It restructured its debts to the Paris Club. But it did not restructure its international sovereign bonds.

Anyone who concluded, based on Russia, that international bonds would be exempt from future restructurings, or would be restructured on better terms than other debt, ended up making a big mistake. Look at Argentina.

One interesting point: Even if 80% of all creditors participate in the deal, the holdouts will hold more international sovereign bonds ($16 billion face, over $20 billion including past due interest) than had been restructured prior to Argentina (I am starting the clock for bond restructurings with the Brady plan, which created the modern international sovereign bond market). Argentina’s default is still not entirely behind it. Its lawyers will be in court fighting off legal challenges for a long-time.