(4/16/2015) The possibility of devaluation is apparently an issue in the upcoming Argentine elections. (The forward rate for next year is about 13 pesos per dollar, which is close to the informal rate and suggests a big devaluation relative to the current official exchange rate of 8.) In this connection, an Argentine newspaper has asked me about “Contractionary Currency Crashes,” a paper that I presented as the 5th Mundell-Fleming Lecture of the IMF’s Annual Research Conference. Continue reading
U.S. federal courts have ruled that Argentina is prohibited from making payments to fulfill 2005 and 2010 agreements with its creditors to restructure its debt, so long as it is not also paying a 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 June 27 that it would be illegal for them to transfer Argentina’s payments to the 92 per cent 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 favor of the holdouts is bad news for the international financial system. It sets back the evolution of the international debt restructuring regime.
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: a 70% “haircut” or loss.
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 nationalized 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 who 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. (And these investors shouldn’t let the name bother them so much; after all vultures have their own ecological niche. When Alexander Hamilton, the first U.S. Treasury Secretary, redeemed the debts of the 13 colonies at full face value, he was well aware that some speculators who bought at deep discount would profit.) 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 (even leaving aside jubilee-style forgiveness by “bleeding-heart social workers”) 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 had been able to persuade Americans like Calvin Coolidge to recognize reality and forgive unrepayable debts of European governments, the history of the interwar period 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: (i) allows employment and production to continue – in those cases where the economic activity is still viable (in re-organized form]; (ii) divides up the remaining assets in an orderly and generally accepted way (even if some creditors oppose the “cramdown”), and (iii) 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).
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. 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.
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 programs went hand in hand with “bailing in” creditor banks through “voluntary” coordinated loan rollovers. Eventually it was recognized that a debt overhang was inhibiting investment and growth in Latin America, to the detriment of both debtor and creditor; after 1989, Brady-Plan write-downs alleviated the debt overhang. Subsequent programs 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.
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. CACs are provisions that are voluntarily agreed to by all participants ahead of time to facilitate restructuring. 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. Restructuring often was too late and too little to restore debt sustainability. But it worked, more or less. (The IMF has continued to work on 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.)
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 per cent 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 United States, greater use of CACs, 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 CACs, though there is probably a fix for this.
Other recent developments have also worked to reverse the progress in the global resolution regime, as 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 enamored of fiscal austerity. The mistakes eventually encompassed even such specific no-nos as a consideration in the Cyprus case of haircutting small bank depositors.
Time will run out for the Land of the Tango by the end of July. 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.
Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy. Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.
As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?
Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall – not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.
The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012). Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent. Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010. Regional growth is projected to ease further to 5.8 percent in 2012.
But will economic slowdown turn to financial crash? Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.
The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?
The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament – in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.
Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.
For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries. The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.
The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996. Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.
Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously? We need some sort of causal theory that could explain such periodicity to international capital flows.
Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.
If emerging markets crash in 2012, remember where you heard it first – in ancient Egypt.