6th August 2014
Jan Dehn, Head of Research at Ashmore discusses the recent news that Argentina defaulted after failing to ensure that holders of 2033 Discount Bonds under New York Law received their coupons on the 30 July, following the expiry of the grace period.
ISDA’s Credit Derivatives Determinations Committee has ruled that a credit event has taken place. Ratings agencies have downgraded bonds to selective default. This does not have direct implications for whether a default occurs under the bond indenture or in CDS, but some investors may have restrictions that prevent them from holding securities rated to be in default by rating agencies.
It is likely that Argentina’s bonds will continue to be included in the main EM benchmark fixed income indices. The main principle of inclusion is not whether a bond is in default or not, but rather whether it is possible for investors to replicate indices. Thus, as long as bonds are traded by market makers they are likely to remain included in the indices.
The outlook for the bonds and for Argentina remains uncertain and is likely to stay that way for some time. There are many possible scenarios of which the most relevant are:
With respect to the holdout investors:
Argentina might still choose to pay holdout investors, but doing so on terms other than those originally offered to exchange bond holders would trigger the so-called RUFO clause. This clause requires Argentina to offer all bond holders improved terms if better terms are extended to holdout investors. This would exceed the resources of the Republic and contradict the Republic’s publicly stated policy not to pay so-called ‘vulture funds’. We therefore think this outcome is unlikely.
Private sector bank syndicates – allegedly independent of the Republic of Argentina – could still buy up NML’s claim (NML is the plaintiff), say, on the belief that they can obtain a better eventual settlement than the price they pay for the claim. In principle, this could cause NML to drop the case. But the respite might be temporary: The so-called ‘me toos’ – other holdout investors with similar claims – could quickly make similar demands and thus make the problem come back. The combined claims of the plaintiff plus the ‘me toos’ is about USD 15bn, which is more than half of Argentina’s FX reserves.
Alternatively, the government could refrain from taking any action whatsoever with respect to the holdouts until after the expiry of the RUFO clause in January 2015. At that point, Argentina would be able to enter into negotiation with all holdout investors instead of just the plaintiff, thus potentially increasing its relative bargaining power. After the expiry of the RUFO clause, holders of restructured debt would not have the right to ask for the same terms as holdout investors.
The government could also opt not to fix the problem with holdout investors at all, giving up on the idea of fixing outstanding issues with the New York Law bonds altogether. In this case, the holdouts would be potentially paid the same 30c to the dollar offered on the 2005 and 2010 restructurings or even never be paid, at least by the current government.
With respect holders of exchange bonds:
The government has repeatedly stated that it will ‘pay’ exchange bond holders. It has not been able to deliver on this promise. Even so, the government says it will continue to send money to the payment agent as a signal of its willingness to pay. This signal of willingness to pay will help, but not necessarily prevent acceleration of the bonds, which could potentially increase the number of holdout investors sharply.
It would be possible for the government to resume normal service of the exchange bonds if a deal is stuck in the courts. This could happen in a number of ways, including:
NML asks Judge Griesa (and Griesa agrees) to re-instate a suspension of his ruling that currently bars the payment of coupons. This could happen, for example, if the government and plaintiffs make progress towards a deal, or if private banks took over the claim from NML.
Bond holders could also come together to waive the RUFO clause. This would require 75% of bond holders. Once the RUFO clause is gone there is nothing (other than Argentina’s domestic constraints) that prevents Argentina from settling with holdouts and such a move would allow for the payment agent to release the funds to pay coupons on exchange bonds.
The government could attempt to swap NY law bonds to local law bonds by offering holders of discount bonds to swap their bonds into identical securities issued under local law, which would be serviced, including the past due coupon. The government has stated on a number occasions that it might undertake such a swap. But the operation is not straight-forward. Not all holders of New York Law bonds might be allowed to hold local law bonds; so they could become new holdout investors. Also, the US court has stated that a swap to local law would constitute an attempt to bypass US law, making it difficult if not impossible for international banks to facilitate such a swap and paying agents to settle the transactions. Of course, that would not prevent an Argentine banking institution from offering to sell local law bonds and buy identical New York Law bonds, as in a normal trading operation. Once an exchange has taken place the local law bonds are then paid along the lines currently used for local law bonds.
The government could also opt to stop servicing the newly defaulted exchange bonds altogether with a view to restructuring the entire debt stock at some unspecified point in the future. This would save Argentina about USD 0.5bn this year (or USD 3.3bn if accelerated), all else even, but raise concerns about the longer-term outlook as Argentina is increasingly isolated. The risk of acceleration would rise. As noted above, acceleration can be remedied, but only within a narrow 60 day window.
What does the default mean for the future of New York Law as a jurisdiction for issuers in EM? The willingness to push Argentina into default to ensure compliance with New York Law certainly increases the credibility of New York Law. On the other hand, this outcome benefits only a very a small number of holdout investors at the expense of the far larger group of holders of performing debt. Bond holders might conclude that a legal framework that places the interests of a minority of holdout investors so far above the interests of the majority of bond holders – the precedent set in this particular situation – is too risky. Holders of Argentina’s New York Law bonds have certainly not been ‘safer’ than holders of local law bonds. Holdout investors have not been paid for more than a decade, while holders of exchange bonds have now been pushed into default. By contrast, holders of the local law Dollar bonds issued since Argentina’s last default have so far been paid in full and are unlikely to be materially affected by Judge Griesa’s ruling.
Issuers might also have second thoughts about issuing under New York Law. After all, many EM countries get hit by occasional weather shocks or outbreaks of political instability, which can inadvertently push them into temporary non-payment (for example, this happened to Ivory Coast not so long ago). When countries are prone to shocks, it is not in their interest to issue under a legal framework that affords so much power to small groups of holdout investors; because it can complicate the process of restructuring (a settlement is easily derailed).
Therefore, the Argentina situation only reinforces existing strong trends towards local law issuance in EM in our view. Most EM countries today rely on local law bonds for the bulk of their financing. In fact, 86% of all EM bonds are in local currency of which the vast majority are in local law. Issuing under another country’s laws is a legacy of a past long gone; today’s reality and the future in EM belongs firmly to local law.
What effect does Argentina’s case have for other countries?
Likely to be very small, mainly due to the slowdown of volumes with trading partners like Brazil. Argentina’s case is unique; no other country in EM is in a similar situation. We think, therefore, that contagion risk from Argentina’s default is extremely small. That is not to say that financial markets will trade Argentina’s misfortune rationally; after all we continue to see periodic outbreaks of irrational EM credit and equities trading, for example when investors dump the entire asset class at signs of uncertainty in developed economies. But it is important to distinguish between price volatility and risk. Not since 1998 has the volatility of EM asset prices had the capacity to derail the economic fundamentals across large numbers of EM countries. In other words, we have not seen an episode of economic contagion for more than one decade. The reason for EM’s fundamental resilience is mainly that EM now principally finances domestically, while EM’s fiscal balances, stocks of reserves and central bank policies have improved dramatically. EM’s price volatility is largely due to investor behaviour, not EM fundamentals. Thus, to the extent that Argentina’s default leads to broader EM asset price weakness this should be viewed as a buying opportunity, in our view.
As for Argentina today, it is a very different situation from 2001. One important difference is that there will be no “break of peg” through a forced conversion of savings from USD to Pesos with an implied 75% devaluation. In 2001, this caused a 25% collapse of the economy alongside a banking crisis. Today, ARS is a dirty floating currency, which has depreciated steadily. The central bank has been accumulating reserves over the recent months and holds USD 29bn in its coffers. The stock market is trading at all-time highs, which is a sign locals are far from panicking. The government has the ability to pay its USD denominated obligations: the total public sector refinancing requirement for the rest of this year is just USD 3.3bn (of which USD 1.9bn are interest payments). Obligations are mainly two payments of USD 200m each on the Bonar 17s and Boden 15s due in October plus some USD 800m of interest payments on the Discount and Par bonds in December (which the government has so far pledged to continue to send to the payment agent). The economic impact is therefore likely to be much more limited than in 2001. Fundamentally, given a net public sector debt stock of just 21% of GDP this default is clearly not due to unwillingness or inability to pay in the conventional sense.
Having said that, all credits are risky and Argentina is a significantly higher risk credit than most in EM. The country has a long history of balance of payments crises, episodes of hyper-inflation and default. The economy is currently in a weak state and the quality of macroeconomic policy is woeful. Argentina has enormous potential in energy, mining, tourism, agriculture and many other industries, but under the current government these strengths are unlikely to be realised. The situation could change next year: Argentina is scheduled to hold elections in October 2015 and President Cristina Kirchner is unable to run for re-election. The current front runners for president include Buenos Aires governor Daniel Scioli and former cabinet chief Sergio Massa. Both are Peronists, but from a different school of Peronism and widely expected to pursue policies that are considerably more market-friendly than the current administration. Whether this is enough to alter Argentina’s longer-term trend of under-performance relative to its potential is far less clear.