Why Argentina Chose Default Over Paying Off Holdouts

Buenos Aires feared settling with Paul Singer and other holdouts would have left it open to claims of up to $120 billion; hopes persist of a negotiated solution.

Views of Buenos Aires As Argentina Faces Possible Bond Default

Flags fly outside the central bank of Argentina in Buenos Aires, Argentina, on Wednesday, July 30, 2014. A top Argentine banker and former Economy Ministry official arrived in New York today to make a last-minute proposal aimed at averting the country’s second default in 13 years. Photographer: Diego Levy/Bloomberg

Diego Levy/Bloomberg

This was a default that wasn’t supposed to happen. Only a week before, experts confidently predicted that Argentina would agree to pay holdout creditors the $1.5 billion they had been demanding, stemming from the country’s last default, in 2001. In return, Argentina would finally regain access to capital markets, reignite investor interest in its agricultural and hydrocarbon riches and resume economic growth. “It would be the difference between night and day,” says Miguel Kiguel, a leading Buenos Aires economist.

But on July 30, negotiations to resolve the impasse broke down as President Cristina Fernández de Kirchner chose a fresh default rather than caving in to the holdouts, who are led by hedge funds NML Capital, an arm of Paul Singer’s Elliott Management Corp., and Aurelius Capital Management. They had won a ruling by New York District Court Judge Thomas Griesa that their bonds be paid at face value before Argentina makes payments on any of its restructured debt. If other holdouts had joined the suit, it might have cost Argentina up to $12 billion to settle with them; the government probably would have paid with new long-term bonds.

“For a country that isn’t otherwise carrying a large debt load, that really isn’t much,” says Alberto Ramos, New York–based co-head of Latin America economic research for Goldman Sachs. Argentina’s debt stood at a manageable 45.6 percent of gross domestic product at the end of last year, and the country has $29 billion in reserves.

So what went so terribly wrong? The government and even many of its political adversaries argued that paying off the holdouts might open the floodgates to far more onerous demands by the majority of creditors, who years earlier had agreed to swap their bond holdings for new issues of deeply discounted bonds.

As the crisis neared climax, one of the most influential proponents of this dire alternate scenario was former Economy minister Roberto Lavagna, who oversaw the restructuring of Argentina’s massive debt following the 2001 default. In 2005 Lavagna pushed through a skeptical Argentinean legislature the Rights Upon Future Offers, or RUFO, clause to the debt-restructuring bill. The measure guaranteed creditors who accepted haircuts of up to 75 percent on their holdings in 2005 that the government would not offer a better deal to any holdouts before January 1, 2015. If the government reneged prior to that date, it would have to compensate all creditors who accepted a haircut. By 2010 only 7 percent of the original defaulted bonds remained in the hands of the holdouts, who continued to demand to be paid at full face value.

“Without the RUFO clause, we would never have been able to get the agreement of the vast majority of creditors for a restructuring of the debt,” Lavagna told Institutional Investor a few days before the default. “And now, all those financial sector charlatans are intent on ignoring the risks involved in paying the holdouts what they are demanding.”

According to Lavagna, those risks might have ended up costing Argentina as much as $120 billion, a figure that includes the world record $95 billion sovereign default in 2001 plus accrued interest payments. Regardless of whether the country would in fact be liable for such a monumental sum, the argument was embraced as a near certainty by both the government and its opponents. So was the refrain coined by Lavagna that Argentina faced a painful choice between the $120 billion “tsunami” and the “typhoon” of a default resulting from a failure to pay the holdouts in full. “A typhoon would be less bad than a tsunami,” said Lavagna.

There is a consensus both in Argentina and abroad that a default this time around would not be nearly so devastating as the last one. In 2001 the country had already suffered through three years of recession that left a quarter of the workforce unemployed. “Back then, Argentina had terrible problems of liquidity and solvency,” says Kiguel, executive director of EconViews, an economic consultancy. “Today, Argentina is facing a much smaller debt. Whatever liquidity problems it has can be remedied quickly through a better economic policy. And the country is a lot more solvent than, say, Greece.”

Even so, the new default will severely test Argentina. The jobless rate is 7 percent, and the country has just entered a recession, which could depress gross domestic product by 4 percent by the end of the year. Inflation is already running at a 35 percent rate and could surge to more than 40 percent. On the black market, the dollar is trading at 50 percent above the official rate against the peso, and it is expected to continue climbing.

In the days leading up to the default, cabinet chief Jorge Capitanich disclosed the government’s plans in the coming months. It will continue paying interest to holders of restructured debt through deposits at the Bank of New York Mellon, Citigroup and JPMorgan Chase & Co., among other banks, even if those institutions withhold payments in keeping with Judge Griesa’s directives. The government will also continue to negotiate with the holdouts until January 1, when the RUFO clause expires — leaving open the possibility of reaching a deal next year.

An earlier resolution is also possible. Banks including Citigroup and JPMorgan were reportedly in discussions with the holdouts about buying their defaulted paper, which could pave the way for Argentina to resume payments on its restructured debt. Prices of that restructured debt took a hit after the default but still traded at levels that indicated investors were betting on some kind of private sector solution.

Meanwhile, at home, the government will try to mitigate the worsening recession through easy credits to consumers for the purchase of homes, cars and household appliances, as well as low-interest loans for small and medium enterprises.

But President Fernández, who has only 15 months left in office, is likely to face mounting political recriminations as the economy sours. Provincial governors, most of them Peronists like the president, will find it difficult if not impossible to issue debt. That will hurt all the more with general elections scheduled for October 2015. “I don’t think Cristina has the support of her own party to follow her into a long, crazy battle,” says Daniel Kerner, a Washington-based analyst with Eurasia Group, a political risk consultancy. “My sense is, they just want this to be over as quickly as possible.”

But the president has remained steadfast. “I am not going to be threatened by warnings that the world will collapse, because what most concerns me is my historic responsibility to my children, grandchildren and the millions of Argentineans,” she said on national television a few days before the default.

Polls indicated that most Argentineans preferred a deal with the holdouts over another default. At the annual exhibition of the Argentine Rural Society in Buenos Aires last week, Alberto Mazzoli escorted his wife and two daughters past a display of prize pedigree cattle and recalled his own experience in the aftermath of the 2001 default. He was finishing up a degree in engineering at the University of Buenos Aires when that crisis exploded, leaving him with no prospects of employment in that field, so instead he became a mechanic at an auto repair shop in Avellaneda, a southern suburb of the capital.

“I shouldn’t complain because there are many who are much worse off than I am,” says Mazzoli. “But I wouldn’t want to see people’s livelihoods crushed again for no good reason.”

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