Tango Down


You can’t deny that things are just not working out for Argentina these days. First, they had their hopes and dreams crushed earlier this summer after they lost against Germany in the World Cup. Obviously, soccer is just a sport. However, its also a way of life in most South American countries. So you can imagine how heartbreaking it must have been for the Argentinians.

To add insult to injury, recently, Argentina also defaulted on part of its sovereign debt. This means that it failed to meet its payment obligation to some of its creditors. Before we continue let me clear up two common misconceptions about sovereign defaults. The first one, is that it occurs when a country goes bankrupt. This is false. Default just refers to not being capable of paying or refusing to pay debt. The fact that Argentina defaulted on its debt was entirely its own decision as I will explain soon. Argentina still had money in its treasury to pay its debt off. Or it could have printed some money to do so; but it refused. The second misconception is that sovereign defaults are very rare occasions that only occur once in a million years when the economy or financial sector of a country is in shambles. This is partly true. Yes, financially troubled countries are more likely to default, but even developed countries can default too. The United States came close to defaulting in 2011 when Congress nearly refused to raise the country’s debt ceiling. The following list of sovereign defaults since 1961 shows that it can happen pretty often.

SIGSovereignDefaults2003

So why did Argentina default? You might have noticed from the table above that Argentina defaulted not too long ago in 2001. The story of Argentina’s most recent default can be actually be traced to its previous one. So lets go back to 1998 to get a better understanding of where we are today.

In order to control the hyperinflation caused by an economic crisis in the late 1980s, Argentina decided to peg its currency, the austral, against the US dollar in 1991. This lowered inflation and caused Argentina’s GDP to grow by nearly 50% between 1990 and 1998. Living standards rose and Argentina was labeled as one of the new emerging economies. However, not everything was as it seemed. Deep down within Argentina’s economy, a crisis was brewing. Argentina was spending a lot more than the revenue it was generating. Thus, the nation’s external debt kept on piling up. A financial crisis that occurred in 1997 in Asia slowed the Argentinian economy and reduced investor confidence in emerging markets such as Argentina. The final piece of the puzzle came when in 1999, Brazil devalued its own currency, causing the Argentinian austral to be less competitive against the currency of its neighbor.

After having enjoyed a honeymoon period during the early 90s, Argentina’s GDP declined by 3% in 1999 and the country entered a three-year long recession. Despite consecutive tax hikes and spending cuts by the Argentinian government, unemployment kept rising, the economy kept on shrinking and borrowing costs rose, making it harder for the the nation to finance its debt. The situation failed to improve as the people took the streets to protest and the IMF refused to keep lending to Argentina. By November of 2001, investors rushed to sell their australs, causing a run on Argentinian banks. Shortly thereafter, Argentina was forced to abandon the currency peg. Finally, on the last week of 2001, the Argentinian government defaulted on $132 billion of public debt. Here are a couple graphs that display how everything went insane in Argentina around 2000.

argentina-gdp-growth

Historical Data Chart

This is where our story truly begins. Until that date, Argentina’s $132 default was the largest in history. Despite cutting off the country from international capital markets, it stopped the Argentinian currency from entering hyperinflation and as the graph depicting Argentina’s GDP growth rate proves, it helped the country to enter a period of growth.  Argentinians are known for their kindness. That’s one of the reasons why their flag has a smiling sun on it. So, in 2005 and 2010, the Argentinian government offered new discount bonds to the holders of its defaulted debt. These bonds pad about 35 cents on the dollar of the original bonds. It was an offer that these investors could not refuse. If they did refuse, they got nothing. They had worthless bonds in their hands. If they said yes, they at least had something. Thus, 93 percent of bondholders agreed to the deal.

Who were the the remaining 7 percent, and what where they thinking? Well, they’re a group of hedge funds including Elliott Management and Aurelius Capital and they decided to take off their investor hats and become lawyers by going on a crusade to get the exact amount of money that they were originally owed. In other words, this was their reaction to Argentina’s proposal.

You see, the original bonds had a clause called parri passu, which means ‘equal treatment’ across all bonds. The holdout investors claimed that this meant that Argentina can’t pay back some bond holders and not the rest. Its a clever argument really. And its also risky. These investors could have taken the easy way out and received the discount bonds. But for years they’ve been going after Argentina to get their money back in its entirety. Its something that only a very determined and diabolical person would do. Paul Singer, the CEO of Elliott Management, the most aggressive hedge fund, fits that persona both characteristically and physically. I mean just look at him. He is a prime candidate to be the next Bond villain.

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“James Bond. Allow me to introduce myself. My name is Ernst Stavro Blofeld. They told me you were assassinated in Hong Kong”

So how have these hedge funds fared over the past decade? Not so successful actually. They attempted to sue Argentina in the past and failed. When it seemed that suing wasn’t working, they turned to seizing Argentinian assets. Not financial assets though, they targeted physical assets. In 2012, Elliott Management seized a frigate belonging to the Argentinian navy off the coast of Ghana as partial payment for the money that it was owed. But this tactic failed as well when Elliott Management were forced to hand the frigate back. I don’t know what is funnier, imagining hedge fund pirates taking over a ship in Armani suits, or that the fact that this ship is still used as a frigate in the Argentinian navy when it clearly belongs in a museum.

The holdouts made their breakthrough in 2012 when a lone judge in New York named Thomas Griesa ruled that the holdouts were correct about the parri passu clause, and that Argentina couldn’t pay the exchanged bonds without paying the holdouts too. To put the pressure even more on Argentina, Judge Griesa ruled that if Argentina refused to pay the holdouts, it would prevent any financial institution from facilitating the payments Argentina maid to the exchanged bondholders. This decision put Argentina in a tough situation because if it didn’t pay the holdout bonds, it would default on all the exchanged bonds, even thought it was willing and able to make the payments. I’m sure this was Paul Singer’s reaction after Judge Griesa’s decision.

Time went by, insults were thrown and meetings were held, but both sides could not come to an agreement by July 30, which was the deadline that Judge Griesa had placed on Argentina. Hence, Argentina defaulted. Besides stubbornness, there were several other reasons for why Argentina refused to pay. Firstly, their foreign currency reserves were running low. At the time of the default, Argentina only had $29 billion in foreign currency reserves. If they paid the holdout investors, then their reserves would reach critically low levels and would greatly effect their monetary policy in the future. The second reason is that Argentina had another clause in their exchange bonds called RUFO ( Rights Upon Future Offers). This clause forbid Argentina from offering any new future bondholders a better deal, without also extending the same deal to exchanged bondholders. In other words, they would have to pay the exchange bondholders the same full amount on each bond just as they would pay to the holdouts. If Argentina broke this clause, they would have been liable to pay the exchanged bondholders approximately $120 billion.

Although the holdouts failed to get what they wanted, they are still searching for ways to shake some cash out of Argentina. On August 11th, a federal court in Las Vegas gave NML Capital, one of the holdout creditors, the right to investigate the US-based companies of an Argentinian businessman named Lazarao Baez.  Mr. Baez is under investigation in Argentina for allegedly embezzling $65m from government contracts. By looking into Baez’s activities, NML hopes to perhaps recover some funds through a court order and to humiliate Argentina for not paying its debts. I think that after defaulting 8 times in its 200 year history, Argentina is impervious to financial humiliation.

So what happens now? Will Argentina’s economy crash again like last time? Not really. This default occurred for obscure legal reasons as opposed to financial reasons. Of course it will continue to cut off Argentina from international capital markets, making it harder for Argentina to borrow, but they were still in that situation anyway. Argentina’s economy will continue to be in stagflation, with negative growth and high inflation. I think they’re used to it by now. Finally, because Argentina’s external debt and GDP is so low compared to the global economy, this default will not have a large effect on global markets.

Historical Data Chart

Nevertheless, I feel bad for the people of Argentina. They’re forced to suffer due to the mismanagement of an incompetent government and the greed of a group of rich hedge fund managers. I think there’s only one man who can solve this problem. The one man that all Argentinians turn to when they are desperate for something miraculous to save them at the last minute…Lionel Messi.

lionel-messi-goal-wc-14

BONUS: If you follow this blog regularly, you would know by now that I like to simplify complicated concepts by using humor and various real life examples. I think it gives a chance for people who are not familiar and not interested in these topics to understand and enjoy reading about these issues. Lets be honest, sovereign debt defaults, hedge funds and RUFO clauses are not the most interesting subjects in the world. As a bonus, I’ve added a video of Felix Salmon, a Reuters reporter, who tries to explain the story of Argentina’s default in even simpler ways than me …by using Legos and action figures. Enjoy.

“This situation thrust upon the Argentine people is also a form of violence. It is a financial missile, which also costs lives”
– Cristina Fernandez de Kirchner, President of Argentina

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