Argentina or the “Principles”?

Argentina's debt default in December 2001 – the biggest in history for any one country – triggered for the nth time the alarm signaling the inadequacy of the international financial system to deal with the risk posed by capital flows to emerging markets. Crises in Mexico, Thailand, Indonesia, Korea, Russia, Brazil and Turkey had preceded Argentina's meltdown by a few years, yet little had been done to improve the system's ability to deal with these episodes.

Argentina's financial collapse was the impetus for serious discussions on how to improve the system. At first – and spearheaded by the IMF – the focus was on creating a formal bankruptcy mechanism for sovereign debtors, but that idea was soon scrapped because it generated strong opposition among both debtors and creditors, who considered a statutory approach to be unnecessary and counterproductive. The emphasis then shifted to a voluntary approach to crisis prevention and resolution. Finally last November, after more than two years of consultations among the main government borrowers and the private lending institutions, an understanding was reached, and the Institute of International Finance issued the "Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets." The "Principles" present a set of voluntary market-based guidelines that promote greater direct cooperation between sovereign-debt issuers in emerging markets and their investors and creditors, in order to avoid crises or, if necessary, cope with those that arise.

Guidelines to Avoid Disaster

The Principles aim to prevent crises by encouraging full transparency on the part of debtors regarding their relevant economic and financial information, their commitment to pursue macroeconomic stability, economic growth and market confidence, as well as their willingness to consult with creditors as soon as any debt-service problems emerge. Under such circumstances creditors will be called upon to consider the rollover of short-term maturities of outstanding loans and the maintenance of trade and interbank lines of credit in order to minimize the risk of market contagion.

For cases in which a debtor cannot fulfill its payment obligations, the Principles advise a process of voluntary debt restructuring essentially aimed at restoring normal market access to the troubled debtor. Emphasis is put on good-faith negotiations and cooperation between the debtor and the creditor community to achieve deals that assure a critical mass of market support for the restructuring, while preventing discrimination among affected creditors. Nothing in the Principles prejudices the outcome of negotiations between issuers and investors, which means negotiations could comprise anything from cases of minor rescheduling to those in which small or big writeoffs prove necessary.

The Principles are also consistent with a fairly new development in the market: bonds that include collective action clauses that allow for amending payment terms if a supermajority of creditors agree – in contrast to the totality that traditionally was required. Since Mexico issued the first bond of this kind under New York law in March 2003, $70 billion worth have been issued by more than 20 countries.

The Argentinean Approach

On paper the Principles look like good guidelines, which – if applied assiduously – would have made less likely, perhaps even impossible, most of the traumatic debt failures that have occurred since Mexico's August 1982 default. The real value of these guidelines will rest, of course, on how well they are implemented and followed by the parties involved. They will be tested not in good times of ample liquidity and reasonable economic growth, as now prevail, but in rougher times of interest-rate spikes and adverse export markets for debtor countries. In the latter situation some debtors will be tempted to ignore the Principles and look toward Argentina's unilateral and confrontational approach. After all, that approach seems to have been successful for the Argentinean government, so far.

After being in default for three years Argentina launched a unilateral offer in January to exchange its defaulted bonds, which carry a principal value plus unpaid interest of about $103 billion, for new bonds. Argentina gave bondholders until Feb. 25 to take the deal or leave it. By the deadline the participation rate in the debt exchange reached 76%. Bondholders who accepted the deal will take a haircut of about 70% on the nominal value of their assets.

Although Argentina will still have to deal with some $20 billion in defaulted debt that was not tendered for exchange, it clearly has gotten a big break. If it adopts the necessary structural reforms, it could transform the economic recovery it's been enjoying since 2003 into a long period of sustained economic growth.

Other nations, however, should not be tempted by Argentina's example of debt management. It was the presence of exceptional geopolitical and economic circumstances that allowed the Argentinean government to get its way. Proliferation of unilateral defaults à la Argentina would be a highly destabilizing force in international capital markets, with dire consequences for debtors and creditors alike. Furthermore, such a proliferation would in all likelihood mean that far fewer resources would be available for financing other emerging economies' development over both the medium and the long term. Stick to the Principles. They're a safer bet.