It Takes More Than Two to Tango

by Jeffrey Frankel, Jeff Frankel’s Weblog

This article appeared 22 July at Voxeu.org.

The US court ruling forcing Argentina to pay its hold-out creditors has big implications. This column argues that some of them are particularly worrying. The court ruling undermines the possibility of negotiated re-structuring of unsustainable debt burdens in future crises. In the future, it will not be not enough for the debtor and 92% of creditors to reach an agreement, if holdouts and a New York judge can block it. This will make both debtors and creditors worse-off.

US federal courts have ruled that Argentina is prohibited from making payments to fulfil 2005 and 2010 agreements with its creditors to restructure its debt, so long as it is not also paying the few creditors that have all along been holdouts from those agreements. The judgment is likely to stick because the judge (Thomas Griesa, in New York) told American banks on 27 June that it would be illegal for them to transfer Argentina’s payments to the 92% of creditors who agreed to be restructured, and because the US Supreme Court in June declined to review the lower court rulings.

It is hard to cry for Argentina or for its President – Cristina Fernández de Kirchner. Nevertheless, the ruling in favour of the holdouts is bad news for the international financial system. It sets back the evolution of the international debt restructuring regime.

The Kirchners and the vultures

Why is it so hard to feel sympathy for a developing country that can’t pay its debts? In the first place, Argentina in 2001 had unilaterally defaulted on the entire $100 billion debt, rather than the usual effort to negotiate new terms with the creditors. Thus, when it finally got around to negotiating a settlement with the 92% majority of bondholders four years later, it could almost dictate the terms – 70% ‘haircut’ or loss (Gelpern 2005).1

In the intervening decade, the Kirchners have gone out of their way to pursue a variety of innovatively bad economic policies, reversing a preceding decade of good policies. Ms. Fernandez has seriously impaired the independence of the central bank and the statistical agency, forcing the adoption of CPI statistics that understate the inflation rate so systematically that most people no longer use them. She has broken contracts and nationalised foreign-owned companies. When prices for Argentina’s leading agricultural export commodities reached very high levels on global markets – a golden opportunity for the country to boost growth of output and foreign exchange earnings (chronically insufficient) – she imposed heavy tariffs and quotas on soy, wheat, and beef exports, thereby preventing producers from taking advantage.

On the other hand, some might counter that the holdout hedge funds that brought the suit to Judge Griesa are not that sympathetic either. Many of them are called ‘vulture funds’ because they are not the original creditors but rather investors who came along later, buying the debt at deep discount, hoping to profit subsequently through court decisions. But all this is beside the point.

The precedent problem

The problem with the Argentine debt case has little to do with moral failings of either the plaintiffs or the defendants. Instead, the problem is the precedent for resolution of international debt crises.

The popular reaction to the recent rulings, even among those less familiar with the sad history, is anti-Argentina. After all, the judge is just enforcing the legal contract embodied in the original bonds, isn’t he? As President Calvin Coolidge supposedly said about American loans to the WWI allies, “They hired the money, didn’t they?”

If only the world were so simple. If only a simple legal regime of consistently enforcing the explicit terms of all loan contracts – by making the debtor pay –were sufficiently practical to be worth pursuing. But capitalists figured out many years ago that the financial system requires procedures for rewriting the terms of debt contracts under extreme circumstances. The British Joint Stock Companies Act of 1857, for example, established the principle of limited liability for corporations. Debt bondage and debtors prison have also been illegal since the 19th century, regardless what the debt contract might say. Individuals can declare bankruptcy. So can corporations, of course. (And if the prophetic Keynes (1920, 1931) had been able to persuade Americans like Calvin Coolidge to recognise reality and forgive unrepayable debts of European governments, the history of the 1930s might have been different.)

Corporate bankruptcy law works relatively well at the national level. There will always be times when it is impossible for a debtor to pay, and admittedly other times, hard to distinguish, when the debtor merely claims that it can’t pay. A poor legal system is one that keeps otherwise viable factories shuttered while assets are frittered away in expensive legal wrangling, and everyone is left worse off. A good legal system is one that:

• Allows employment and production to continue – in those cases where the economic activity is still viable (in re-organised form);
• Divides up the remaining assets in an orderly and generally accepted way (even if some creditors oppose the ‘cramdown’), and
• Makes these determinations as efficiently and speedily as possible and with the minimum of moral hazard (by imposing costs on managers, lenders, shareholders, and – if necessary – bondholders, so as to avoid encouraging future carelessness, see Panizza 2013).

No such debtors’ court or body of law exists at the international level. Some think that this long-standing lacuna is the primary difficulty with the international debt system (Sachs 1995). Ambitious proposals to solve it over the years, such as a Sovereign Debt Restructuring Mechanism (SDRM) which might be housed at the IMF, have always run into political roadblocks (CIEPR 2013, Eichengreen 2013).

But incremental steps had been slowly moving the system in the right direction since the 1980s. In the international debt crisis that began in 1982, IMF country adjustment programmes went hand in hand with ‘bailing in’ creditor banks through ‘voluntary’ coordinated loan rollovers. Eventually it was recognised that a debt overhang was inhibiting investment and growth in Latin America (Krugman 1988 and Borensztein 1990), to the detriment of both debtor and creditor; after 1989, Brady-Plan write-downs alleviated the debt overhang (Sachs 1990). Subsequent programmes to deal with emerging market crises featured an analogous combination of country adjustment and ‘private sector involvement’ (such as agreement by lenders to stretch out maturities). Voluntary debt exchange offers worked, roughly speaking, with investors accepting haircuts (Frankel and Roubini 2001, Sturzenegger and Zettelmeyer 2005). After Argentina’s unilateral default in 2001, many borrowers and lenders saw more clearly the need to allow explicitly for less drastic alternatives ahead of time and so incorporated more ‘collective action clauses’ when writing their lending contracts (Eichengreen et al. 1995). Collective action clauses are provisions that are voluntarily agreed to by all participants ahead of time to facilitate restructuring (Eichengreen and Mody 2000). They make it possible, if the borrower subsequently runs into trouble, to restructure debt when a substantial majority of creditors wishes to do so, even if a few hold-outs do not. The minority is then bound by the majority decision.

The incremental steps had created a loose sort of system of debt restructuring. It still had many deficiencies (IMF 2014). Restructuring often was too late and too little to restore debt sustainability. But it worked, more or less.2

The real danger of the court ruling in the case of the Argentine hold-outs is that, in a parochial instinct to enforce a written contract, it will undermine the possibility of negotiated re-structuring of unsustainable debt burdens in future crises because free-riding holdouts may be able to prevent it. Contrary to the saying, it takes more than two to tango. It is not enough for the debtor and 92% of creditors to reach an agreement, if holdouts and a New York judge can block it.

The court delivered a peculiar interpretation of the pari passu (equal treatment) clause that is standard in many sovereign debt contracts. It interpreted pari passu to mean that creditors who had not agreed to the debt exchange were to be paid 100% of the original claim at the expense of the creditors that had accepted the new bonds. Moreover, the court gave the holdouts a very powerful weapon to enforce their claims by holding settlement and clearing institutions in the US and even in Europe responsible for routing any payments of Argentina.

Financial markets may find a way around the precedent of the court ruling in future contracts. Likely responses to the problem include a shift toward writing contracts outside the US, greater use of collective action clauses, and elaboration of the pari passu clause. But some warn of extra-territorial reach by the US court. Some even think the decision could inadvertently interfere with collective action clauses, thoughthere is probably a fix for this (Gelpern 2012).

Other recent developments have also worked to reverse the progress in the global resolution regime, as slow and inadequate as it already had been. Europe’s handling of the crisis that began with Greece in 2010 was too slow, too optimistic, too reluctant initially to restructure bond-holders, and too enamoured of fiscal austerity. The mistakes eventually encompassed even such specific no-no’s as a consideration in the Cyprus case of haircutting small bank depositors.

Time will have run out for the Land of the Tango by the end of July 2014. Perhaps the result of the court decision will be that, unable to pay all its debts, Argentina will be forced instead to default on all its debts. More likely, in the end it will manage to come to some accommodation that hold-outs find more attractive than the deal accepted by the other creditors. Regardless, the outcome will undermine voluntary debt workout agreements in the future. This is bound to make debtors and creditors alike worse off.

Editor’s note: A condensed version appears at Project Syndicate.

References

Borensztein E (1990), “Debt overhang, credit rationing and investment”, Journal of Development Economics, Vol. 32, Issue 2.

Committee on International Economic Policy and Reform (2013), “Revisiting Sovereign Bankruptcy”, October.

Eichengreen B (2003), “Restructuring Sovereign Debt”, Journal of Economic Perspectives, Vol. 17, No 4.

Eichengreen B and A Mody (2000), “Would Collection Action Clauses Raise Borrowing Costs?” NBER working paper No. 7458.

Eichengreen B, R Baldwin and R Portes, Crisis? What crisis? Orderly workouts for sovereign debtors, CEPR, October 1.

Frankel J (2011), “The ECB’s three mistakes in the Greek Debt Crisis”, project-syndicate.org, 12 May

Frankel J (2014), “Sovereign debt at square one”, project-syndicate.org, 17 July

Frankel J and N Roubini (2001), “The role of industrial country policies in emerging market crises”, NBER working paper No. 8634.

Gelpern A (2005), “After Argentina”, Policy Briefs in International Economics, No. PB05-02, September.

Gelpern A (2012), “Sovereign restructuring after NML vs. Argentina: CACs don’t make pari passu go away”, Creditslips.org, 3 May

IMF (2014), “The Fund’s lending framework and sovereign debt-preliminary considerations”, Staff Report, June.

Keynes J M (1920), The economic consequences of the peace, New York: Harcourt, Brace and Howe.

Keynes J M (1931), Essays in Persuasion, London: Macmillian.

Krugman P (1988), “Financing vs. Forgiving a Debt overhang”, Journal of Development Economics, Vol. 29, Issue 3.

Panizza U (2013), “Do We Need a Mechanism for Solving Sovereign Debt Crises? A Rule-Based Discussion”, Graduate Institute Geneva Working Paper No. 03/2013.

Sachs J (1990), “A Strategy for Efficient Debt Reduction”, Journal of Economic Perspectives, Vol.4, No. 1

Sachs J (1995), “Do we need an international lender of last resort”, Frank D. Graham Lecture, Princeton.

Schadler S (2013), “Unsustainable debt and the political economy of lending: Constraining the IMF’s role in sovereign debt crises”, CIGI paper No. 19.

Sturzenegger F and J Zettelmeyer (2005), “Haircuts: Investigating Investors’ Losses in Sovereign Debt Restructurings, 1998-2005”, IMF working paper, WP/05/137.

Footnote

1. It was inexplicable that the Bush White House – after complaining that its Clinton Administration predecessors had supposedly bailed out all comers in the emerging market crises of the 1990s – over-ruled the IMF staff and leadership to insist on continuing to roll over IMF loans to Argentina even in 2003. By then, Argentina had shown intransigence toward its creditors, defied the usual IMF program conditions, and abandoned its role as a model for economic reform in South America, under Ms. Fernandez’s husband and predecessor, Néstor Kirchner. Bailouts create the most moral hazard when the gap between policymakers’ ex ante rhetoric and ex post practice is the biggest. (As for the systemic risk argument, the Emerging Markets contagion of the late 1990s had fully run its course. And, for good measure, the geopolitical/security angle was notably absent as well: Henry Kissinger described Argentina as a dagger pointed at the heart of Antarctica.)
2. The IMF has continued to think of ways to make its biggest rescue programs conditional not just on country reforms but also in some cases on private sector involvement, in the form of reprofiling or, when necessary, reduction of debt.