Now, Argentina's Default Looks Inevitable

With the U.S. preoccupied, a bailout is unlikely

Things in Buenos Aires seem to be going from bad to worse. Any hopes that Argentina would eventually emerge from a four-year recession were snuffed out by the September 11 terrorist attacks, which dealt a body blow to the global economy. Argentine bonds are now trading at less than 60 cents to the dollar. Meanwhile, local interest rates have soared to a punishing 35%, even for blue-chip borrowers. These are signs that the markets believe that Argentina cannot go on servicing its $132 billion national debt. U.S. rating agencies are assuming as much. On Oct. 9, Standard & Poor's Corp. downgraded Argentina's sovereign debt rating to CCC+, putting the country on a par with deadbeats such as Ecuador. Rival Moody's Investors Service quickly followed suit.

Wall Street has already resigned itself to the idea of an Argentine default. A recent survey of emerging-market portfolio managers by Morgan Stanley Dean Witter & Co. revealed that 85% now believe default is inevitable. The hope is that an end to what is being called the longest train wreck in history will at least relieve pressure on other emerging markets. Brazil, for instance, has seen its currency lose close to 30% of its value against the dollar since the start of the year, partly on concerns about Argentina's solvency. The steep depreciation of the real makes it more costly for Brazil to service its own domestic debt, a large portion of which is dollar-indexed. "The message the rating agencies and the investor community are giving is, we need to let whatever is going to happen, happen," says Ignacio E. Sosa, a principal at OneWorld Investments, a $275 million hedge fund based in Boston. "The longer it takes, the more potential damage to Brazil."

Just about the only thing left standing between Argentina and default is the country's strong-willed Economy Minister, Domingo Cavallo. Every time it looks as if cash-strapped Buenos Aires is going to concede defeat, Cavallo manages to pull off another last-minute save. In May, he persuaded foreign investors to swap $30 billion worth of Argentine treasuries for paper of longer maturities and higher interest rates.

Now, Cavallo is trying a similar move with local pension funds and banks, a number of which are foreign- owned. Yet this time, he expects domestic bondholders to tender securities carrying rates as high as 26% in exchange for new ones with rates as low as 7%--hardly a lucrative proposition and a sign that the government is increasingly desperate. Officials claim the transaction, which could encompass more than $10 billion worth of paper, is voluntary. Indeed, local banks and pension funds may be wagering that an orderly restructuring--which is what the debt swap really is--is preferable to a messy default that would leave investors much worse off. Yet in the view of S&P, the government's plan amounts to a "selective default."

SOCIAL UNREST. Indeed, to many, Cavallo's actions are a futile attempt to postpone the inevitable. To its credit, the government has made progress toward its goal of erasing a pernicious fiscal deficit by pushing through draconian cuts in public-sector salaries and pensions. But these increasingly potent doses of austerity have stoked social unrest and turned voters against President Fernando de la Rua and his ruling Alliance coalition. And, according to current projections, Argentina still faces a $2.1 billion budget shortfall in the fourth quarter and a $4.3 billion gap for all of next year. "It's clear that the fiscal targets won't be reached without some sort of outside assistance," says Pablo Guidotti, a vice-economy minister under former President Carlos Menem.

One forlorn hope is that the U.S. will ride to Argentina's rescue, as it did several times during the 1990s. Yet Washington is probably too preoccupied with the war on terrorism these days to devote much attention to Argentina's plight. The U.S. Treasury greenlighted an $8 billion rescue package from the International Monetary Fund in August. Approximately $3 billion of that figure was earmarked for some sort of debt swap that would be attractive enough to lure investors.

But analysts say Argentina needs much more than $3 billion to pull off a successful exchange. But U.S. Treasury Secretary Paul H. O'Neill has long expressed his uneasiness over such giant bailouts. Besides, an Argentine bailout would open the U.S. to an endless list of handout requests from other struggling economies, many of whom are better-positioned geopolitically, such as Pakistan or Turkey, to aid the Bush Administration in its quest to root out terrorism. In the final act of this financial drama, Buenos Aires may have the stage all to itself.

By Joshua Goodman in Buenos Aires

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