Refusing to play the restructuring game

Argentina has re-written the rule book on sovereign debt by refusing to pay back its bondholders.

And it is easy to understand the logic behind this move. A country that defaults on its external debt pays a huge price both politically and economically. Once that price is paid, however, it starts to recover. The cost of curing the default is large; the benefits are vague, and far in the future ? certainly at least one election cycle away.

One veteran observer of sovereign behaviour puts it this way: "For 22 years, we've all assumed that a sovereign debtor in trouble wishes to preserve its market reputation, and wants to impose as small a haircut as possible on its creditors. But after a certain amount of time in default, the psychology completely shifts. Indeed, maybe the quickest way to resume market access is to bring devastation to the existing creditor group."

Most sovereign debt restructurings work on the principle that the creditors minimize their haircut, start getting coupon payments again, and usher the debtor back to the international capital markets.

That is precisely what has happened until now. "Most governments have cleared their debts extraordinarily quickly," says Vincent Truglia, co-head of sovereign ratings at Moody's. "It was in the self-interest of Ecuador, Pakistan, Ukraine, Russia, and Uruguay to resolve their problems."

In denial

In the case of Argentina, the sovereign doesn't buy that argument any more. For one thing, the present government barely recognizes most of the debt as its own: it claims it was lent to crooks by crooks and doesn't see why the new administration should have to spend billions of dollars repaying it.

What's more, finance minister Roberto Lavagna claims to have learnt the lesson from the Menem years that borrowing abroad can have disastrous consequences. Therefore, he says, he won't do it, even if the markets are willing to lend to him.

And it is doubtful that they would. The country's contingent liabilities to the banking and utility sectors are so enormous that there's almost no conceivable way, short of outright debt forgiveness by the IMF, that it is going to be creditworthy in the foreseeable future.

The upshot, says Truglia, is that "the decisions of the Argentine government could be extraordinarily rational: it's running a current-account surplus, and can finance the domestic deficit through monetary emission without inflation concerns for the next one to two years."

Besides, Argentina privatized virtually everything in the Menem years, which means that the country has very few assets with which it can generate revenues to pay off creditors.

The country's approach makes it almost impossible for bondholders to persuade it that there are good reasons for it to be more creditor-friendly.

Realizing this, Argentina's creditors have started going to court. There is some debate about whether judgment creditors are effectively senior to bondholders or not, but they certainly have a lot more rights. Recently, a number of class-action suits were certified against Argentina in a New York court: this is very bad news indeed for the country, since those kind of suits are almost impossible to settle, and the possible sovereign liability is huge.

If anything, the chances of Argentina getting a successful bond exchange off the ground are probably significantly lower than the chances of the country finally severing its ties with the IMF and defaulting on its World Bank obligations.

Investors hope that the situation in  Argentina will prove to be one-off rather than a template of sovereign debt crises to come. The country did, after all, experience a combination of fiery populist rhetoric, large foreign debt, currency mismatches, and the collapse of property rights and the rule of law. Compared with that, the present crisis in the Dominican Republic, say, is minor.

There is a silver lining to the Argentine chaos, however. At the moment, the Argentine economy is rebounding quickly, and could well be the subject of envious glances from elsewhere in the region.

But when the next round of creditor chaos hits, the populist approach will look rather less attractive. Argentina will stand for many years as a lesson in what happens when populism is taken to its logical conclusion.