Of all the defaults through Argentina’s history, the one on august 3rd 2014 is the strangest to date. Moreover, its implications could spill over to the rest of global markets.
In its two-hundred year history, Argentina has defaulted on its debt an average of once every twenty-five years. Its August 3rd default may be the strangest to date: Argentina attempted to make its regular payments to creditors – it even sent the money to Bank of New York Mellon for processing – but a ruling by the US District Court for the Southern District of New York prevented the payments from being delivered.
The injunction was the latest in a long-fought saga between the Elliot Management, a New York hedge fund that invests in distressed debt, and the Argentinian government following its prior default in 2001 (watch this video for a thorough and entertaining primer). The situation, especially over the last month, has become by far the most disturbing storyline in sovereign debt markets.
The default has raised more questions than answers on what will happen next, but those questions spill over to the rest of global markets as well .Here are just a couple of the questions Argentina’s situation has opened:
Who has sovereignty over sovereign debt decisions?
When the Supreme Court refused to hear Argentina’s case in June, Argentina ran out of options in the US legal system. The issue then became whether Argentina would comply with District Court Judge Thomas Griesa’s ruling that no bondholders can receive payments from Argentina unless all of them do – even those like Elliot Management, who never agreed to a haircut. So far, Argentina has not complied and nor will it, since US federal courts cannot force a sovereign nation to obey its rulings. What the court can do, however, is put pressure on any US financial institution that could abet Argentina’s non-compliance.
That is exactly what Judge Griesa has done through an injunction on Argentina’s trustee, Bank of New York Mellon. The bank will not deliver the money that Argentina deposited with it until the injunction is lifted, leaving it in a tug-of-war between its commitments and obligations to two nation’s governments. More recently, Argentina filed a case with the International Court of Justice arguing that Judge Griesa’s decision is a breach of sovereignty. It is not immediately clear whether the US will acknowledge the case, or even recognize the Court since it only does so on a case-by-case basis.
The precedent being set – that a US federal court can dictate terms of other nations’ sovereign debt simply because Wall Street is in the US – could induce moral hazard for aggressive US investors like Elliot Management, who want the high yields of emerging market debt without the risks. A spending spree on the basis that any losses from default will be nullified by US courts would be a dangerous precedent for sovereign debt markets.
It could also spur protectionism in sovereign debt issuance in an attempt to block out this type of vulture investor. That would mean governments would be blocked from a portion of demand for their debt and may have to pay higher interest rates to finance itself.
What good is a CDS if no one knows whether it triggered?
Argentina officially defaulted on June 31 after Judge Griesa’s injunction forced it to miss $539 million in payments on bonds that mature in 2033. This was not a surprising result given the inability of Argentina and the hold-outs to settle their dispute. What was surprising, however, was the weakness this event exposed in other financial instruments.
Credit default swaps (CDS) are essentially insurance policies on specific debtors. If Argentina fails to pay any portion of its debt, then a CDS holder is entitled to a payment from the CDS’s issuer. So when Argentina defaulted, all CDS for Argentina were triggered – right? Well, the answer to that question is not as easy as it sounds, especially since Argentina intended to pay and had delivered the money to its trustee. Eventually, the International Swaps and Derivatives Association had to step in to eliminate the uncertainty. It declared that a credit event had occurred, triggering approximately $5.3 million worth of CDS on Argentina.
$5.3 million of securities is just a rounding error for most banks’ balance sheets, but this is an example of a potential weakness in CDS: it is a financial instrument designed to hedge risk and lower uncertainty. But if holders of CDS cannot determine whether the terms of the swap have been triggered, CDS only increase uncertainty. Even if it takes a couple days for ISDA to make a ruling, banks and institutional investors are suddenly exposed to all sorts of risk they thought they were insulated from – when they had paid a fee purchase insurance against that risk. Even hedges like this can prove fickle in the face of a politicized international financial dispute.
Could this happen elsewhere?
The 2001 Argentinian default that began this fiasco was not caused by fiscal mismanagement; it was caused by ludicrous monetary policy that pegged the Argentine peso at a 1-to-1 rate with the US Dollar. When capital quickly flowed out of Argentina following the Asian Financial Crisis, the central bank was forced to issue mountains of debt to support the 1-to-1 rate. Eventually the task became too large, Argentina realized that a fixed exchange rate was a terrible policy, and opted for the clean slate of a default.
Argentina was far from the first emerging market to have the horrendous idea of pegging exchange rates to a developed market currency. Outside of Middle East oil and quasi-Euro area countries, there are a few notable currency pegs. 14 West African countries, including Ivory Coast and Cameroon, are pegged to the Euro through the CFA Franc.
Also notable is Venezuela, whose peg with the US Dollar is becoming increasingly precarious. Even after announcing some easing of rates, the Bolivar remains overvalued by a factor of 13. Earlier this year, Venezuela ran afoul with several foreign companies, refusing to deliver payments to US and European airlines and Chinese rail developers. Although Venezuela’s anti-market history under Hugo Chávez made its economy less intertwined with global markets, there is potential for a replay of the Argentinian situation there in the coming years.
