The next corralito: Argentina defaults on its debt obligations and thus offers a lesson to the investors in US, Europe and Puerto Rico.
Argentina didn’t even take 13 years to default on its debt for the second time in the modern age. The Economist calls the Argentina debt crisis as “an economic crisis beyond compare” and the “corralito” – basically a financial playpen of sorts – was the long-lasting result that saw bank accounts frozen and the Argentine peso reduced to rubble after a decade being pegged to the US dollar.
Argentina had time until midnight on 30th July 2014 to avoid going into default for the 8th time in its history. The story leading to this deadline started way back in 2001, the last time Argentina defaulted on its debt obligations. In an attempt to manage country’s debt, the then government in Buenos Aires offered bondholders a deal in which they would get regular payments of interest provided they accepted a more than 70% reduction in the value of their investment. More than 92% of its creditors agreed for a settlement and swapped their defaulted debt for new securities in two restructurings that took place in 2005 and 2010. But a few creditors, led by a hedge fund called NML Capital, didn’t approve off this settlement. NML Capital wanted full payment of principal plus interest in the New York courts, under whose law the original bonds were issued.
Argentina argued that the funds bought most of the debt at a deep discount after the default and has sought to thwart the country's efforts to restructure in two separate debt swaps in 2005 and 2010. Argentina grew rapidly after it devalued the peso and defaulted on around $100bn of debt in 2002 but has since suffered from uncomfortably high levels of inflation.
It is this protracted legal battle that had brought Argentina on the verge of another default. In 2012, Thomas Griesa, a New York district-court judge, gave judgment in favour of NML Capital and banned Argentina from paying to the creditors who held exchanged bonds if Argentina didn’t pay to NML what it wants. Judge Griesa’s ruling was based on pari passu clause (pari passu clause entitles all creditors to equal treatment) which was a term in the contract under which the original bonds were issued.
In June 2014, United States’ Supreme Court refused to intervene in the case leaving Judge Griesa’s ruling intact and Argentina with following choices:
a) Pay NML $1.3 billion plus interest as awarded by court.
b) Negotiate a settlement with the hedge fund; or
c) Stop the payment to the exchange bond holders.
On June 30th, a payment which was due to those exchange bond holders was missed, and subsequently Argentina again defaulted on July 30th on which date the grace period expired.
The international capital markets had been under the assumption that some sort of settlement would be reached and that would be in the interest of exchange bond holders, who would keep getting paid. It would also suit the holdouts. Such settlements would raise Argentina in the eyes of international capital markets and bring Argentina on the path of rehabilitation.
However, the time is passing by and there is no sign of noticeable negotiation. President Cristina Fernandez de Kirchner has never supported stumping up to the “holdout” creditors—also dubbed vulture funds. Argentina claims that it can’t enter into a settlement with the holdouts without potentially triggering a Rights Upon Future Offers (RUFO) clause included as a term of issuing its restructured bonds. This clause expires on Dec 31st 2014, and categorically states that Argentina can’t voluntarily offer holdouts a better deal than it did during its 2005 and 2010 restructurings without extending the offer to all bondholders.
Argentina’s request for a stay on the decision until after the RUFO clause expires was rejected by Judge Griesa. It was quite possible that the Judge might have looked more kindly on a request for a stay from NML itself. However, that didn’t happen and Argentina defaulted again in the absence of last-minute settlement.
Argentina ultimately defaulted on 30th July, and the result was wide-spread ramifications. Various rating agencies downgraded the country to a status of "partial", "technical", "restricted" or "selective" default. S&P also downgraded Argentina's rating from CCC- to "selective default".
Share prices also fell by 6% at the start of trading in Buenos Aires and the price of Argentinian bonds fell after America's Supreme Court refused to hear an appeal against a ruling by a lower court that came down in favour of creditors who bought up debt worth $1.3bn (£770m).
The "upfront cost" of a five-year credit default swap surged from 36% to 46% – meaning it would cost almost half the face value of a bond to insure it each year.
In just one day, dozens were killed as riots consumed Buenos Aires and citizens shouted to throw the bums out. Most of the cabinet resigned and political turmoil was in full force.
By the time it was all over, fifty percent of Argentines were poor and the economy had cratered more than 20% in just a few years.
Of course, the already rampant inflation rates got far, far worse as the value of the Argentine peso, no longer able to rest on its US dollar peg.
First, runaway government spending. The government’s already nine-figure debt became unmanageable as Argentina’s government took on more and more foreign and domestic debt and saw their interest rates shoot through the ceiling.
Second, in an attempt to end their last bout of hyperinflation, some experts at the central bank pegged the peso to the US dollar. That was still the “strong dollar” era, and the government figured such a policy was a road to riches.
Of course, what happened is that Argentina’s neighbors merely benefitted from the newly strong peso and took a lot of business away from Argentina.
Lastly, a wave of privatization created conditions that were impossible for the average Argentine to manage. In addition to a new round of inflation from bad government monetary policy, some of the privatization involved crony capitalist deals where bureaucrats got paid off and looked the other way when utility prices suddenly went through the roof.
Now that she is all but shut out of the world financial markets and declared a rogue state, Argentina’s psychopath president Cristina Fernandez de Kirchner is trying to rehabilitate the country’s image.
However, “Argentina defaults on debt” is not exactly a new headline. In fact, it’s been seen eight times before, starting in 1828, when Argentina defaulted on its very first bond, 44 years ahead of schedule. Current bondholders might take solace in the fact that that stand-off took 30 years to resolve.
While Argentina has one of the world’s most sophisticated populations, an endless supply of excellent land, and great natural resources, they can’t seem to get it together.
Domingo Cavallo, the architect of Argentina’s first debt restructuring deal in 2001, has a solution for the country’s worsening debt drama: pay the holdouts.
According to Mr. Cavallo, “Argentina should comply with Judge Griesa’s decision”. He said if Argentina continued to make payments to bondholders who participated in past debt restructurings, it must pay in full the investors who declined to take part.
In addition to pushing Argentina to its second default in 13 years, the decision had wider ramifications. Officials in the United States Treasury Department and the International Monetary Fund have said the ruling will make future debt restructurings much more difficult because investors will have incentive to not reach a deal and instead will hold out for full payment on their bonds.
If a new government comes in and stabilizes the economy with responsible policies, Mr. Cavallo said, he thinks that billions of dollars of capital that has left the country will return. Under these improved economic conditions, he added, the government should be able to pay the so-called vulture investors.
If you’re an international investor or freedom seeker looking to diversify your assets around the world, there are several simple, logical steps which experts recommend.
1. Avoid governments with high debt levels.
High debt levels indicate fiscal irresponsibility. The United States government has Exhibit such irresponsibility, arrogantly believing that no matter how much they spend, they’ll still be rich.
Apparently no US politicians have ever heard of the Greek, Roman, British, or Ottoman Empires that rose and fell largely due to the same mismanagement.
There are plenty of countries running relatively tight ships. Singapore, for instance, has no net debt. Even socialist Norway has used their oil resources to actually create wealth, unlike The Land of the Free that has squandered it.
Agencies like S&P are now putting the hurt on Argentina as a result of its debt default, and that will cause even more problems for the Argentine people as costs rise. Even the US is not immune to this outcome, and experts suspect that one will see more riots and more mayhem in countries where the spigot of easy money gets turned off abruptly.
2. Diversify out of the US dollar
Argentina figured hitching their cart to the US dollar wagon would solve all of their problems. It ended up causing them a lot of problems.
This is one reason some experts are more excited about Asia than Latin America. While Central America offers some of the world’s best residency opportunities for perpetual travelers, it is by its very nature tied to the US economy and US spending.
This trend is headed in the right direction, but dollarized economies like Panama is a cause of concern. Even here in Asia, people in Hong Kong are suffering inflation as a result of their Hong Kong dollar being tied to the greenback.
At least the Hong Kong Dollar offers the potential of switching its peg to the Renmibi, or being replaced by the Renmibi altogether at some point.
3. Live and invest in economies based on culture
for years, Argentina has thumbed its nose at the world. It had no problem taking their money for their pet projects and to enrich the government, then balked at repaying their loans.
As a result, Argentina has become a basket case, complete with a healthy black market for foreign currency as the government has had to crack down on anyone with money. Argentines have been prohibited from owing foreign currencies or even taking money out of the country.
Capital controls became the norm.
One may enjoy living in a country that bullies the rest of the world… until the bully’s chickens come home to roost. Argentina is once again paying the price for having a government culture that played the victim rather than actually inviting people to do business there and respecting capital.
Argentina disrespected capital, and it got what it deserved. Argentina is a proof that, no matter which bankrupt country one lives in, the splatter is coming. Argentines saw their entire nest egg vanish almost overnight because they believed their government would protect them and their money, which didn’t happen.
This article is written by Karan Singhania, a PGP2 student at IIM Ahmedabad