Making Argentina's Debt Debacle a Rarity
The epic battle between Argentina and a group of U.S. hedge funds illustrates a fundamental flaw in the sovereign bond market: There's no orderly, well-established way for financially troubled governments to get relief from their creditors.
The best solution is to design the bonds so they act more like stock.
Argentina's current difficulties can be traced back to the early 2000s, when a severe economic slump rendered the government unable to make payments on some $95 billion in debt. Several years later, the government wore down most of its creditors into accepting new bonds worth roughly 30 cents on the dollar. A small group of holdouts, including hedge fund Elliott Management Corporation, chose instead to pursue their legal right to full repayment.
The ensuing litigation has created a big mess. A U.S. judge has blocked payment to other creditors until the holdouts are paid. Argentina won't pay, so it's back in default. While almost no one has sympathy for the rogue Argentine government, some also fault the U.S. courts for a decision that will further complicate all debt restructurings. If distressed sovereigns can't get relief from the private investors who bought their bonds, they'll have to rely even more on the stretched resources of organizations such as the International Monetary Fund.
The courts don't deserve the blame. They're merely enforcing contracts that seek to maintain the fiction that sovereign debt always gets paid. These contracts require large majorities of bondholders to agree to changes, giving small groups leverage to seek preferential terms -- more so when several bonds need restructuring. As a result, renegotiation is extremely difficult, and officials put off default as long as possible -- an approach that typically entails bailing out private investors at great cost to taxpayers and magnifies the eventual economic damage.
Various proposals have emerged to improve the contracts. The International Capital Market Association, for example, has suggested a complex set of rules that would lower the percentage of creditors required to agree to restructurings. These, however, would remain subject to interpretation and challenge.
A better approach would be to build the possibility of payment changes into the contract in the first place. If, say, a government's cost of borrowing rose above a certain pre-agreed level, it would have the option of deferring payment until the situation improved. Creditors would share more of the risk of bad outcomes -- much as a company's equity holders share in losses and forego dividends in difficult times. Repayment obligations would be predictably eased to handle contingencies, avoiding the angst associated with renegotiating the contract.
Such automatic debt forgiveness makes sense from the creditors' perspective, because it increases the likelihood that the rest of the debt will be repaid. Investors would require higher returns to compensate for the added risk -- something that should be seen as a benefit, not a flaw. As it stands, the illusion of low borrowing costs encourages governments to take on too much debt and ultimately impose losses on vulnerable groups such as pensioners instead of on private bondholders.
Consider what would have happened if a threshold of, say, 5 percentage points above German bunds had been in place for Ireland, Portugal and Spain during the recent European financial crisis. The ability to halt debt payments would have helped governments get through the hard times without imposing so much suffering on their people, supporting a more rapid return to growth. Possibly, the European Central Bank wouldn't have needed to promise to do "whatever it takes" to restore calm in markets.
The governments wouldn't want to take advantage of the option to stop payments: If they did, the cost of new borrowing would rise. In the longer run, such market discipline would put pressure on governments to reduce debt loads and practice greater fiscal prudence -- far more effectively than the illogical and fractious efforts of official lenders from the European Union.
The elevation of the sovereign bondholder to a privileged creditor reflects a self-serving status quo fostered by financial lobbies and policy elites. Although efforts to undo the system will meet with predictable resistance, the technical challenges are no greater than those of the capital markets association's proposal. Certainly, the potential benefits outweigh any initial difficulties in introducing a new kind of bond -- one very similar to the contingent convertible, or "coco," bonds that many banks are already issuing.
No contract is perfect, but governments can greatly improve upon the current system of sovereign bonds. Everyone will be better off if they do.
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