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How not to default on sovereign debt

Jul 8, 2014

Argentina's bond dispute offers important lessons for sovereign restructurings, writes former finance minister Domingo Cavallo


Domingo Cavallo, former Argentine
economy minister, says Rights Upon
Future Offer clauses should be
avoided in sovereign debt
restructurings 
Argentina declared default on its sovereign debt in December 2001. After debt swaps in 2005 and 2010, it restructured 93% of the bonds, leaving holdout representing 7% of the original defaulted amount.

In spite of these exchanges, Argentina could not re-access the international capital markets and in June 2014 a New York court ruling impeded normal servicing of the restructured bonds, unless Argentina pays simultaneously the total amount due to the holdout bondholders that won the case.

If Argentina does not comply, by July 30 it will default on its restructured bonds. And if it complies, legal opinions argue that the holders of restructured bonds have the right to request equal treatment to that finally given to the holdouts.

So, Argentina's sovereign debt situation looks today even worse than at the end of 2001. Total public debt increased from $144bn in 2001 to $225bn in 2013 and the value in circulation of bonds under foreign jurisdiction is now higher than by the end of 2001.

This is the consequence of having defaulted in a disorderly way and having conducted a process of debt restructuring without the support of the IMF and in a way that the creditors did not consider a negotiation in good faith.

In the second semester of 2001, it became clear that Argentina had lost access to the international capital markets. This happened in spite of all the previous efforts to conduct a voluntary re-profiling of the debt (the so-called shield or "blindaje" and the mega-swap or "megacanje").

The IMF approved a program that, in addition to an immediate disbursement of $5bn to rebuild foreign reserves, promised an additional disbursement of $3bn to support a process of orderly debt restructuring. Additionally, Argentina was expecting two pending quarterly disbursement of the so called "Shield Program" of the end of 2000 of $1.28bn each.

The Argentine government as well the IMF were concerned then by the possibility of a restructuring that would open the door to judicial suits by the holdouts. That could eventually make the restructuring totally ineffective and even counterproductive.

We started to work on a program to conduct an orderly process of debt restructuring on the advice of Jacob Frenkel, then at Merrill Lynch. He brought to our attention the possibility of using "Exit Consent Clauses" to substitute for the missing "Collective Action Clauses" that Argentina, as most emerging markets, had not yet used when issuing its bonds.

The Exit Consent Clauses, as with the CACs, facilitate the imposition on 100% of the bonds restructuring conditions accepted by 66% or 75% of the bondholders, depending on the jurisdiction. That happens because by the approval of the Exit Consent Clauses, whoever holds the old bonds loses an effective way to request the full repayment through a judicial suit.

To prepare for an exchange of the bonds issued in foreign jurisdiction that would have high chances of approving the exit consent clauses, we decided to start the process of orderly debt restructuring by offering an exchange of bonds into loans to the government at a maximum interest rate of 7 % and a maturity extension of three years. The repayment of the loan was guaranteed by the revenue of the financial transaction tax that would go directly to an escrow account in the Central Bank.

This first stage of the restructuring was closed successfully on November 30, 2001 by an amount of $40bn, representing 43% of the stock of bonds in circulation. In the case of the bonds issued under jurisdiction of the US, like those that had emerged from the mega-swap of May 2001, the submission of bonds amounted to 90% of the total. This result reflected the support of pension funds, local banks and other institutional investors, as well as a good number of Argentinean holders of bonds, for the orderly process of debt restructuring.

A condition of this exchange stated that the government acquired the voting power of the bonds transformed into loans. So, it was clear that an exchange offering for the bonds that remained in circulation could easily reach the proportion of votes to approve the exit consent clauses, particularly for the more important bonds, which carried higher interest rates.

At the moment of closing the exchange of guaranteed loans for bonds, the government had already designed an advisory group of bankers for the preparation of the offering. The advisory group was integrated by Jacob Frenkel, Bill Rhodes and Joe Ackerman. The purpose of such an advisory board was to demonstrate that Argentina wanted to conduct negotiations in good faith.

The target was to exchange the old bonds for new ones with the same principal but a maximum interest rate of 5% and a three year maturity extension. It meant a 200bp difference with the interest rate paid on the guaranteed loans because the latter had been issued under Argentinean law. 200bp was the normal interest margin the market required to accept the local jurisdiction.

Unfortunately the IMF announced the suspension of the program on December 5, 2001, and the government fell on December 20. Payments on the foreign debt were formally suspended on December 28 and the complete default on the public debt came a few days later, when President Duhalde announced the "Pesofication" of all contracts denominated in foreign currencies under Argentinean law.

  Argentine public debt ($bn)
  Dec 31, 2001  Dec 31, 2013 
   Total  144 225 
 
   Public bonds  55  154
   National currency (local law)  2  33
   Foreign currency (local law)  9  66
   Foreign currency (foreign law)  45  55
   - bonds issued in the past  29
   - estimated holdouts  20
   - Repsol bonds  6
 
  Loans  83  52
   Guaranteed loans (from swap)  42  3
   International organizations  32  19
   Official institutions  5  10
   Commercial banks  2  5
   Central bank  30
   Treasury bills  7  4
   Other creditors  2  4
 
  Source: Domingo Cavallo/Ministry of Economy of Argentina
   
The decision to transform dollars into pesos meant the exchange into guaranteed loans was reversed - so the total stock of bonds that existed before the first stage of the orderly restructuring process was now in default, not only those that had not been transformed into guaranteed loans.

The new government decided to maintain the suspension of payments for a long period of time and the program of orderly debt restructuring was completely abandoned.

Taking the opportunity to offer two successive swaps, in 2005 and 2010, the Kirchner government did not try to apply Exit Consent Clauses and passed a law declaring that the debt of the holdouts would never be paid. At the same time, they included a Rights Upon Future Offers (RUFO) clause in the restructured bonds that gives their holders the right to request equal treatment with the holdouts if before December 31, 2014 they were paid in better conditions than those accepted in the 2005 and 2010 exchanges.

So now, after the decision of the New York courts, Argentina is facing a situation which is worse than that that it faced in December 2001.

We can conclude that when a country loses access to international capital markets it should avoid a disorderly debt default. It should look for support of the international financial organizations (primarily the IMF) and conduct a negotiation in good faith.

If the bonds to be restructured do not include CACs, the country should try to use Exit Consent Clauses or some kind of enhancement to secure the largest possible participation. In no case should the new bonds include a RUFO clause.

If for some bonds the holdouts have a blocking power, it is better to negotiate with them separately than engaging in a long judicial dispute. The cases of Uruguay in 2002 and Greece in 2012 are good examples of orderly processes of debt restructuring. LF

Domingo Cavallo is a partner at GlobalSource Partners. He was Argentine economy minister between 1991 and 1996, and again in 2001. LatinFinance named him Man of the Year in 1992 for a stabilization plan that included pegging the austral to the dollar after protracted instability.



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