'Vultures' circle Argentina

Economic chaos ensued when Argentina found itself unable to meet payments on its dollar-denominated bonds twelve and a half years ago. Now the country is at risk of a second sovereign default, connected to the same bond debts it had to suspend payments on in 2001.

The new danger is driven by the legal maneuverings of hedge funds that bought Argentine bonds for pennies on the dollar several years ago. Investment funds owned by New York billionaire Paul Singer are at the heart of the battle. Singer's funds specialize in buying distressed debt cheaply and then suing for full payment.

Recovery at risk

Argentina's sovereign bond default in late 2001 came at the climax of a four-year economic depression that started in 1998, after a decade of poorly implemented market reforms coupled with excessive borrowing left the country wide open to international financial flows.

International investors suddenly pulled their money out of Latin America after the Russian and Brazilian financial crises of 2008 caused a loss of confidence in all emerging markets, and Argentina's economy fell off a cliff.

From mid-1998 to the end of 2001, GDP shrank by 28 percent. Mass unemployment and widespread poverty led to violent riots and political instability in 2001.

As that year ended, an interim government declared its inability to meet payments on 82 billion dollars in dollar-denominated government bonds. A few weeks later, the government cancelled the Argentine peso's fixed exchange rate with the US dollar.

While it had initially provided stability, the peg became a source of inflexibility that prolonged the country's economic depression. Investors pulled most of their dollars out of the country.

Allowing the peso to fall meant Argentina could more easily adjust to changes in global economic conditions. But the immediate effect was to deepen the country's economic turmoil.

Since early 2003, Argentina has been governed by the Kirchners: Nestor Kirchner (2003-7) and his wife, Cristina Fernandez de Kirchner (2007-present). From 2003-8, Argentina averaged 9 percent annual GDP growth, substantial increases in real wages and a reduction in poverty. But the country was hit hard by the global recession that started in 2008, and its recovery since has been slow.

A decade of debt talks

Argentina was unable to borrow dollars after its national debt default at the end of 2001. Its government needed to regain access to international capital markets to be able to pay for imported goods and services.

To make that possible, the Argentine finance ministry needed its creditors to accept major debt restructuring, so that Argentina could resume payments on the accumulated national debt, but at a pace and level it could afford.

In 2005, after years of acrimonious negotiations, many bondholders agreed to a deal in which they traded defaulted bonds for new ones. Argentina offered to pay between 25 and 29 percent of face value.

These creditors recognized that the country was simply unable to pay more and accepted the offer, but a minority held out until 2010, when most of the remainder accepted the same terms.

At that point, 91.3 percent of the original defaulted debt had been restructured. However, a small minority continued to challenge the settlement in US and European courts. They demanded that the pre-2002-issue bonds they held be paid in full.

In 2010, these creditors held bonds amounting to about 11 billion dollars in nominal value, today worth 15 billion dollars including principal and accrued interest. The Argentine government has refused to negotiate with them, saying they must accept the same terms as the others. It is these holdouts who are the source of Argentina's present reappearance in the financial news.

A ruthless profit strategy

Economists talk about "the holdout problem" in debt restructuring cases. If most of a debtor nation's creditors accept a "haircut," or a reduction in their claims, the debtor will be better able to invest in infrastructure, education, social welfare, and other measures that will help it to grow its economy. A better economy and stronger growth will in turn increase the nation's ability to service its outstanding debts.

This means that holdout creditors stand to gain at the expense of those who accepted haircuts, because it was the others' sacrifice that led to the increase in value of the bonds held by the holdouts.

In some cases, these are not even among the original, pre-default bondholders, but speculators who buy distressed bonds cheaply, as Singer's investment fund did, and then refuse restructuring deals. In 2008, for example, the fund bought Argentine bonds in default for 49 million dollars that would be worth 832 million dollars if paid out at full face value.

Investment companies that follow this essentially parasitic investment strategy are often called "vulture funds." In Argentina's case, they have waged a decade-long legal battle to try to force the country to pay the full face value of the bonds in their possession.

Unfortunately for Argentina, it made the fateful decision to accept the jurisdiction of New York courts, rather than Argentinian courts, as part of the terms of its debt restructuring agreements with the majority of bondholders in 2005 and 2010.

In 2013, hedge funds controlled by Singer and his allies managed to obtain a favorable ruling from New York federal district court judge Thomas Griesa. It forbade Argentina from making payments to the bondholders who had agreed to restructuring unless it paid full face value to the vulture funds.

The ruling is a potential a disaster for Argentina, because the terms of its debt restructuring agreement specify that if Argentina offers better terms to any bondholder, it must offer the same terms to all others.

The 120-billion-dollar ruling

This means that if Argentina pays out the vultures as Griega directed, it would in effect be obligated to restore the full face value of its entire pre-2002 bond issue. The Argentine finance ministry says the country's sovereign debt would suddenly swell by about 120 billion dollars - an impossible amount. Argentina would be forced into default.

Argentina tried to appeal the decision to the US Supreme Court. But a few days ago, the justices refused to hear the case, exhausting the appeals process. Griesa's ruling stands.

Fernandez calls the ruling "blackmail," and says the country cannot and will not agree to pay out the vulture funds in full. Her government continues to insist the holdouts accept the same terms the other bondholders accepted in 2005 and 2010.

If refusal to pay the vultures leads to a failure to pay all the other bondholders, another Argentine sovereign debt default will result. That's why the lives of millions of people will be affected by the outcome of what may seem, at first glance, an arcane legal dispute within the intricate maze of the global financial system.

Argentina's fightback

On Tuesday (24.6.2014), Argentina's government published a full-page statement in major newspapers: "The vulture funds ... purchased bonds in default at obscenely low prices for the sole purpose of engaging in litigation against Argentina and making an enormous profit."

The statement says Griesa's ruling undermines all future restructurings: "This precedent means that even if 99.9 percent voluntary acceptance were to be achieved, 0.1 percent of creditors could invalidate the whole restructuring."

But many experts believe that Argentina will now have to give the vultures much of what they want, because another default could unleash an economic catastrophe. Fernandez said this week that she will send a negotiating team.

That seems like a reward for the vulture funds' lack of good faith. But as Columbia University economist Jose Antonio Ocampo wrote in the Financial Times on Monday (23.6.2014), the final effect may mean the end of these practices. "It makes the negotiation of an international bankruptcy regime inevitable."