The first default on an international sovereign bond since the 1930s took place on September 28. That date was the last chance for Ecuador to meet a $44.5 million coupon payment on one of its Brady bonds. This event, which passed without much comment from world leaders, has greater significance for the relationship between the rich world and emerging markets than Ecuador's small size would suggest. It marks the start of a new approach by the governments of the developed world and the IMF to countries that get into trouble with their balance of payments. And it teaches investors, bankers and other borrowers their first lessons in how sovereign Eurobond default will work in practice.
Few doubt that the IMF gave Ecuador a nod and a wink to default on its bond debt. The timing was the give-away. On August 25, Ecuador's president, Jamil Mahuad, announced that his country would not meet the coupon payment due on two of its Brady bonds. It would invoke a grace period that gave it 30 days to come up with the money or an alternative solution. Then, on August 31, the IMF said it had reached preliminary agreement on a loan for Ecuador.
In the subsequent weeks, the IMF made little effort to deny that the two events were connected. The message to other countries in trouble was clear: if you want support from the IMF you must restructure your privately held debt including Eurobonds first. This is the policy that the rich world's governments have been edging towards for the past year. And Ecuador, unlike Russia, is small enough to be the test-bed.
In late August Ecuador's options seemed clear: it could pay the coupons within 30 days and avoid default; it could default on its Brady bonds and continue to service its other obligations; or it could announce a general moratorium and begin discussions on a restructuring of all its debt. But its preferred option was none of these, it was to offer Brady investors a new bond in exchange for their Brady bonds. These new instruments would cost Ecuador less to service than the Brady bonds, but bondholders would, it was hoped, take what was on offer.
September 1999 was a time of rapid learning for all sides about what could and could not be done in the event of sovereign non-payment. The outcome, a partial Brady bond default, has been a surprise and disappointment to almost everyone. From Ecuador's point of view it is unsatisfactory: it does little to help the country's debt-service problem; it doesn't satisfy those Ecuadorians who wanted the government to tell investors to kiss their money goodbye; and it still leaves the country exposed to the risk of damaging litigation and leaves it shut off from the capital markets. From the point of view of investors it sets the precedent that countries can meet some of their bond obligations but not others and it calls into question the usefulness of the original Brady bond structure.
The first lesson learnt last month was that a Brady bond exchange in circumstances of imminent default is a non-starter. Other countries with Bradys outstanding have swapped them for less onerous bonds when the capital markets have moved in their favour. And in early September the Ecuadorian government clearly thought it could do the same. It floated proposals that involved giving Brady bondholders a new instrument with a lower nominal amount in place of their bonds. Coupon payments, according to some rumours, could be backed by oil revenues. But it soon became clear that investors would accept nothing of the sort. A glance at the overall structure of Ecuador's debt and its repayment schedule shows why.
Not the biggest headache
Bradys may be Ecuador's biggest class of bonds outstanding but with their low coupons they are not the government's biggest headache in the medium term. The debt service on the government's much smaller stock of domestic debt, most of which is dollar-denominated or dollar-linked, is greater than that on the Brady bonds and the Eurobonds combined. And Ecuador's $500 million of Eurobonds, although they form only a small part of the debt stock, will prove a thorny problem when they amortize in 2002 and 2004.
Michael Gavin, economist at Warburg Dillon Read (WDR) in New York, calculated that if Ecuador's Bradys were restructured in isolation there would be virtually no cash left to meet payments on whatever new bond the government offered Brady bondholders. Whatever stream of payments the Ecuadorians promised in place of the Bradys would have to be discounted to take account of the probability that it would actually materialize. As a result, even a relatively generous exchange offer would be turned down by investors.
The second thing Ecuador and other sovereign borrowers learnt last month was just how hard it is to restructure bonds. The documentation of most international issues is specifically designed to prevent one issue being in default while another continues to be serviced. If a creditor defaults on one of its bonds, a vote of only 25% of the holders of any other of its bonds will force accelerated repayment.
If sovereign Eurobonds are designed to make default difficult, Brady bonds make it tortuous. They require the agreement of 100% of investors for any change in the terms. And they give bondholders a claim on any other payment leaving the country in the case of non-payment. In fact, Brady bondholders might be able to grab any sort of asset leaving Ecuador. A litigious bondholder could even obtain an injunction to seize oil export shipments. "These bonds were structured never to be defaulted on," says Jerome Booth, head of research at Ashmore, an emerging-markets investment fund. Late last month Ecuador's government was known to be taking steps to repatriate assets held offshore.
Going for the weakest
The main lesson investors learnt last month was that defaulters will always try to pick off the weakest creditors first. Russia has specialized in playing off one class of creditor against another, first by defaulting on its domestic debt while keeping up its Eurobond payments and more recently by attempting to restructure Soviet-era debt that is now technically an obligation of the Russian finance ministry.