Will Debt-Ridden Brazil Follow Argentina’s Lead?

With the successful termination of Argentina’s debt swap offer on February 25, President Kirchner’s economic team stands victorious in its struggle against international lending agencies.

Argentina’s triumph represents a new precedent for debt management procedures with international lending institutions. Neighboring debt-ridden governments of Brazil and Venezuela are likely now to follow Argentina’s lead.

Much of Argentina’s debt restructuring success is owed to the laid-back role played by the IMF, which did not pressure the country for an arrangement far more favorable to Buenos Aires’ international creditors than its own citizens.

On February 25, Argentina closed a new chapter in its crisis-ridden financial history while setting a new precedent for the international financial community as it laughed off its recently earned nickname, ‘rogue debtor.’

After four years of sitting on its more than one hundred billion dollar defaulted debt, the country offered its creditors a pittance of its total obligations to them, which was finally accepted only hours before the expiration of the deadline for its proffered debt swap.

This occurred when the Argentine Bond Restructuring Agency (ABRA) creditors accepted the offer’s terms, thereby pushing the participation rate above the Kirchner government’s established threshold of success, 70 percent of the total debt.

To protect recent moves to strengthen his now growing economy, President Nestor Kirchner’s economic team exchanged new government bonds with a record-low offering price in order to liquidate the country’s outstanding debt.

This arrangement represented a significant victory in the international financial arena on behalf of all emerging markets: for the first time, creditors could not count on the automatic support of a hard-hearted International Monetary Fund (IMF) and the U.S. Federal Reserve, but instead were forced to accede to the debtor country’s stark terms without recourse.

The Buenos Aires debt restructuring scheme was crafted by Economic Minister Roberto Lavagna and was aimed to alleviate Argentina’s $102.6 billion of exposure held in default since the 2001 crisis. Following months of rancorous talks and speculation, Lavagna’s ministry of the economy and production planners made public Argentina’s debt exchange offer on January 12.

As outlined in the terms of the government’s proposal, creditors were given six weeks, starting January 14 and ending February 25, to accept new government bonds in exchange for Argentina’s outstanding debts.

The offer addressed $81.8 billion of the defaulted debt, a figure that outraged creditors claimed ignored significant tardy interest payments – which would have swelled the amount on this debt segment to at least $100 billion.

Foreign bondholders then accused the Kirchner economic team of providing preferential treatment to domestic lenders. In October 2004, the Kirchner administration settled with the Argentine Private Pension Funds (AFJPs), which held an estimated 20 percent of the country’s total arrears, by swapping new bonds for $16 billion worth of already defaulted ones.

This arrangement provided domestic lenders with government bonds with shorter maturities than those which they replaced; other bonds with longer maturities were later offered to international lending institutions.

Furthermore, the deal offered perspective recipients approximately 35 percent of the face value of the outstanding bonds. The threshold of success was built into the offer; creditors holding at least 70 percent of the total debt would have had to accept Buenos Aires’ offer in order for Argentina to swap $41.8 billion in new depreciated bonds.

With a lower participation rate, the deal offered would have come to a smaller $38.5 billion. The fourth point of the arrangement delineated a February 25 expiration date. Under the offer’s ‘Most Favored Creditor’ clause, Argentina would have to begin anew to re-negotiate the debt abatement proposal with all the creditors that had accepted its offer if, at any time before 2014, the administration decided to negotiate with any creditor who previously had opted to reject the once closed swap arrangement.

Recent Economic and Political Turmoil

The Argentina 2005 debt restructuring program was made necessary by the country’s experience with neoliberal economic shock therapy initiated by President Carlos Menem (1989-1999).

The most controversial and eventually destructive part of his economic package was the ‘convertability law’ that, in 1991, pegged the Argentine peso with a one to one ratio to the U.S. dollar.

While achieving the initial goal of dampening the economy’s soaring inflation rate in the late 1980s and early 1990s, the implementation of Menem’s economic plan throughout the 1990s continuously failed to meet annual fiscal targets to reduce the budget deficit.

Critics emphasize that the president and his finance minister, Domingo Cavallo, who was imprisoned in 2002 for his participation in illegal arms sales throughout his tenure, borrowed irresponsibly throughout the 1990s.

Poor maintenance of the pegged currency combined with social austerity measures throughout the decade increased already gross inequality. In the beginning of the 1990s, the richest decile of the population enjoyed 15 times more income than the bottom decile. By 2002, this gap had increased to a ratio of 28:1.

Similarly demonstrating the increasing gap between the rich and the poor, primary education completion rates dropped from 32 percent in 1991 to 28 percent in 2003, while secondary and tertiary education completion rates rose by four and three percentage points respectively.

An outraged Argentine electorate reacted against the deteriorating situation in 1999 by electing Fernando de la Rua, leader of the Radical Civil Union (UCR) which had then recently joined up in an electoral pact with the left-leaning Alliance for Work, Justice, and Education (Alianza).

This bloc was formed with a mission to remove the corruption-plagued Menem government from power. However, after only a short period, the de la Rua administration collapsed due to its corruption and inability to alleviate the country’s economic woes.

After a decade of the currency convertibility arrangement maintained by Argentina’s administrations and supported by the IMF – which feared the reverberations of an Argentine currency devaluation and sought to make the nation a free market success story – de la Rua was forced to loosen the peg in the summer of 2001.

In July, the Argentine peso was re-valued to reflect a combined euro-dollar rate, and the government implemented a differentiated exchange rate for imports and exports. To curb speculation-driven capital flight out of the country, the Argentine government announced a freeze on bank deposits and withdrawals, which then spurred violent street protests that pushed de la Rua to resign.

Congress immediately installed Adolfo Rodrí­guez Saá in office, who at the time was Peronist Justice Party (PJ) governor of San Luis. His term lasted only one week, but included the notable announcement of the country’s inability to repay its debts.

Amidst the upheaval, Eduardo Duhalde was sworn in as president on January 1, 2002. He immediately imposed a moratorium on servicing the public debt, devalued the Argentine peso, and converted all financial contracts to peso valuations.

While Duhalde’s measures devastated the balance sheets of private foreign banks in the country, his administration set the stage for stabilizing the economy.

Politically astute as the PJ leader and former governor of the Buenos Aires province, Duhalde successfully moved presidential elections to March 2003 and turned over the government to Nestor Kirchner via a constitutional succession.

The Kirchner Strategy Left to revive the prostrate country amidst its major economic and social upheaval, Lavagna and Kirchner focused on restructuring the country’s debt.

Immediately, they suspended the re-negotiations then going on between the government and private utility companies and concentrated on settling the country’s arrears with its financial lenders.

Their success in shrinking Argentina’s debt was the result of three factors. First, the enormous amount of debt involved – a sum of more than $100 billion – threatened to shake international markets if the settlement process failed.

Second, Kirchner and Lavagna craftily maneuvered within the international financial machinery, using its own procedures in their brazen struggle to achieve major debt reduction.

Third, and most importantly, the IMF and the U.S. did not apply their usual pressure which inevitably favors lending institutions.

Since taking up their fateful debt restructuring project in 2003, Kirchner and Lavagna have deftly managed their nation’s massive debt, primarily by avoiding any linkage to state assets.

In doing so, the government loosened the legal ties between the state of Argentina and such assets, a move that made it all but impossible for creditors to attach state properties or be able to readily seize its liquid assets.

Even after having refused to curb domestic spending, the Kirchner administration may now claim it achieved economic stability as a result of its strategy by pointing to the country’s economic growth rates.

These amounted to more than an 8 percent increase in GDP and were bolstered by cuts in inflation during each of the last two years. Kirchner’s boosters can also cite other current market indicators, such as record highs for Argentine stocks on Wall Street in February 2005 and an increasing flow of foreign investment. 

In response to the many legal claims brought by international creditors against the country, Argentina earlier had sought protection by appealing to the Bank of International Settlements (BIS), whose administrative decisions essentially created a legal force field between the country and its creditors.

Under pressure during the six-week offer window, private credit institutions holding some of Argentina’s defaulted debts found little recourse but to accept the government’s meager offer.

When President Kirchner first announced his plan in October 2004, the Global Committee of Argentine Bondholders (GCAB) – formed by the German and Italian individual bondholders – demanded that the Argentine authorities make a higher offer and proposed, as the main source for the augmented repayments, that the government implement strict austerity measures.

The bondholders claimed that Argentina was not playing by the rules of international finance and, with a 35 percent acceptance rate three weeks into the offer, GCAB Co-chairman Hans Humes suggested that the low participation was ‘a very clear sign that Argentina will do anything it can to lie, cheat and bully people into accepting an unacceptable deal.’

This frustrated group of creditors unsuccessfully demanded that the IMF refuse negotiations on future loans to Argentina despite the institution’s role as a facilitator in the deal’s successful resolution.

As the GCAB’s ‘bully’ accusations against the South American country suggest, the Argentine government assumed a commanding position in maneuvering the debt restructuring deal, one normally discharged by the IMF.

The international financial institution lost effective leverage over providing advice to and demanding consent from Argentina’s economic ministry after releasing a report in July 2004 in which it admitted its own organizational failures in Argentina that helped drive the country into economic collapse.

As the report details, doubts regarding the currency peg noted by involved IMF staff were hushed by an IMF executive board that was anxious to keep on presenting a Latin American success story and fearful that speculative capital flight from Argentina would occur if the IMF body permitted the peso’s devaluation.

IMF representatives ignored the country’s limited progress on necessary economic reforms and continued to promise funds to the government as late as 2000, when it pledged an additional $22 billion.

During the pervasive economic collapse of 2001 and 2002, the IMF then demanded reforms ‘in a way absent throughout the 1990s’ and ‘under a schedule that is oblivious to the political realities of the country,’ according to Lavagna.

As a result, the IMF has lost its status as the omniscient source of economic expertise and, therefore, its ability to force a deal more favorable to a country’s creditors.

With international financial institutions held at bay, Kirchner’s economic team today is standing tall. Even so, its bold and unprecedented move may condemn it to isolation by international lenders in the future.

However wise they may have been for the country’s own domestic stability, Argentina’s actions have taken a heavy toll on all players in international finance, particularly outside investors.

Kirchner’s Jabs Have Landed

Kirchner’s hits have landed hardest on international banks. After providing preferential treatment to domestic banking institutions, Argentina’s offer leaves international private banks recovering a mere 30 percent of the total amount of principle and interest owed.

Equally shaken are international bond traders, who find that their bond holdings have dropped in value by one third along with the decline of the Argentine peso.

Prior to the Argentine swap, international lending institutions explicitly held the upper hand during debt restructuring negotiations, while indebted countries were automatically heavily pressured by the IMF, an agency historically under the operational surveillance of the U.S. Federal Reserve.

In 1982, Mexico became the first case of a country to default on its international debt. The then Mexican finance minister flew to Washington, D.C. over the infamous ‘Mexican Weekend’ to declare his country’s credit obligations unmanageable, before consulting creditors or international institutions.

This led to the Brady Plan that protected bond traders but not necessarily financial institutions from a major crisis. Throughout the 1990s, debt crises in Brazil, Mexico, and East Asia were addressed by international forums.

With the bond traders taking the hit in those instances, financial banks and finance ministers of debtor countries simply hammered out a settlement, always well above the meager 30 percent repayment figure eventually accepted by Argentina’s creditors.

Recalling the lender-dominated debt negotiations of recent history, some 39 lawsuits have been filed against Argentina by bondholders who refused the country’s offer and now are attempting to recuperate $7 billion in defaulted bonds.

NML Capital, a hedge fund based in the Cayman Islands, brought the first case and claimed that the defaulted bonds remain Argentine government property; however, Buenos Aires maintains the position that the bonds now belong to the bondholders that agreed to participate in their swap arrangement.

On Tuesday, March 29, U.S. Federal Judge Thomas Griesa decided to maintain a freeze on the defaulted bonds after frustrated investors appealed his initial decision to lift the freeze, a judgment that would have favored Argentina by facilitating the timely commencement of the debt exchange.

Argentine financial markets, whose indices all increased in the days following Judge Griesa’s decision, demonstrated confidence in a quick resolution. In a similar case in a U.S. appeals court, the bench ruled in favor of the provincial government of Mendoza in 2004.

Therefore, most analysts, including those of Credit Suisse First Boston, expect that delays in closing the debt swap will be insignificant. Resolution of the lawsuits will seal Argentina’s most audacious fiscal legerdemain.

Even as the non-participating lenders seek assistance within its court system, the U.S. has not intervened significantly in Argentina’s settlement process.

The impact of Argentina’s successful debt restructuring lies in the boldness, if not the brilliance, of its sovereign debt management.

While the pending lawsuits may challenge the offer’s final terms, signs from the international financial institutions and markets have suggested that Argentina has indeed closed its books on its great 2001 debt default.

Signifying that no permanent breach has occurred, a team from the IMF met with the Kirchner administration throughout the week of March 14. The talks included a previously scheduled payment of $302 million to the IMF and also a discussion of future lending arrangements.

Additionally, private creditors may not be able to resist future relations with a growing Argentine economy, in spite of the disastrous nature of their past dealings.

In 2005, Argentina has demonstrated to the world that the previously almighty international financial institutions may now, and in the future, prove more willing to listen to the plaints of finance ministers around the world.

With regional cooperation growing throughout the southern cone of the Americas, the IMF may expect similar approaches to be taken by Argentina’s neighboring states.

As Kirchner has made strengthening Mercosur a priority, fellow left-of-center Presidents Inácio Lula da Silva of Brazil and Hugo Chávez of Venezuela may follow his lead in restructuring their countries’ external debts that combined exceed $250 billion.

If successful debt restructuring is subsequently carried out, the international financial community may finally learn the importance of working with, instead of being relatively disengaged from, debtor countries whose first priority must be the welfare of their own citizens.

This analysis was prepared by COHA Research Associate Matthew M. Daly.

The Council on Hemispheric Affairs (COHA) – www.coha.org – is a think tank established in 1975 to discuss and promote inter-American relationship. Email: coha@coha.org.


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