Bonds Economy ENG Latin America Market Strategy

Market Focus: Argentina’s upcoming sovereign debt restructuring

Once again, Argentina is embarked on a complicated debt restructuring process. This post exposes some key facts and figure and makes some observations from the macro and legal perspectives.

Following the visit of a delegation of the IMF to Argentina on February 19, the message cannot be more clear for the country’s foreign private creditors : they will have to make a significant effort in order to lower the debt burden under which the country is bending.

This comes as no surprise. In fact, the market has already recognised this outcome on August 12, 2019, when Alberto Fernandez, the Peronist contender for the Presidency, won a primary election over the incumbent President, Mauricio Macro. The Argentinian people massively rejected the austerity policies implemented by the incumbent President, who had been elected in 2015 with a promise to overturn a country plagued by decades of longstanding economic and social problems. The Peronist candidate made clear that in case he were elected he would seek to renegotiate the country’s foreign debt, drawing an example from Uruguay’s orderly debt restructuring achieved in 2003. Argentina has already gone through a painful economic and financial crisis in 2001 that forced the government at that time to default on 95 billion dollars of foreign currency debt.

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Argentina, 6.875% 22 apr 2021, USD. Source : CBONDS

In its July 2019 review, the IMF still expected Argentina’s debt to be sustainable, but during its visit in February this year it made clear this was no more the case. Actually, the worse case stress test scenario projected in the DSA (Debt Sustainability Analysis) exercise performed mid-2019 by the IMF – namely a combined macro-fiscal shock – turned out to reflect more accurately the unfolding developments than the baseline scenario.

As, the IMF team warned in the 2019 Article IV report (p. 2):

Gross financing needs are high and a wavering in market confidence can quickly translate into higher sovereign spreads, difficulty meeting fiscal financing needs, a shift in investor preferences away from peso assets, and pressures on the exchange rate (which directly feed back into the debt dynamics given the large share of the debt in foregin currency).

This is precisely what happened in the second half of the year, all the more as the new President, Alberto Fernandez, announced that he was going to loosen the fiscal stance  – in order to improve the living conditions of the people and to support growth – and to carry over in a more resolute manner the voluntary reprofiling of the external debt that had already been announced by his predecessor in September 2019, just before the final round of the Presidential election. Public debt reached 90% of GDP in December 2019 or 323 billion US dollars, of which 173 billion US dollars (55% of total debt) was composed of market traded debt in foreign currency (155,4 billion dollars of foreign currency bonds and 18,2 billion of foreign currency bills). Simultaneously, the foreign currency reserves of BCRA, the country’s central bank, experienced a sharp drop in Q4 2019 falling down to 45 billion dollars by January 2020.

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Argentina’s public and external finances are in a dire state. The current and fiscal imbalances that have been accumulating since 2011-2012 have been compounded by the fall of the Argentinian peso against the US dollar the first half of 2018 – as a result of an a emerging markets sell-off and risk aversion episode – and on August 12, 2019 in the wake of the primary election results, which led to a massive withdrawal of US dollar deposits held in Argentinian banks (cf. charts below). Inflation went out of control, moving from an already high 25% yoy growth in April 2018 to a record 57% yoy growth in May 2018 and staying above 50% yoy afterwards. This did not prevent the ratio of total public debt to GDP from rising sharply by 30 percentage points between 2017 and 2018 and by another 10 percentage points in 2019 to 90% of GDP. In addition, interest service on public debt rose to 7% of GDP, explaining the worsening of the fiscal balance in the run up to the Presidential election, even though the primary balance has been brought into positive territory by the Macri government.

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In 2018, the IMF granted a record 50 billion US dollars – extended to 57 billion dollars – loan under a stand-by arrangement.  Out of this total, 44 billion dollars have already been disbursed. Given the record amount of the IMF loan and its narrow amortization profile over the 2021-2024 period, it is relevant to question the soundness of this loan, especially given the “track record” of the country, its growing reliance on international capital markets starting from 2016 and its longstanding economic problems. The IMF seems to have finally acknowledged this risk in its 2019 Article IV report, as it states:

The Fund’s exposure in terms of debt service metrics remain at the higher end compared to other exceptional access cases, and the frontloaded disbursement schedule implies a considerable bunching of Argentina’s repurchase obligations to the Fund.

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In addition to a probable extension of the IMF financial assistance program, which would delay the repayment schedule by 36-48 months, the new Argentinian government represented by the new economy minister, Martin Guzman – a 37 years old former Research associate at Columbia University with no capital markets or public service  experience -, is embarked in a tough negotiation with the country’s external private creditors, over around 90 billion dollars of outstanding debt in foreign currency (80 billion dollars of government bonds in foreign currency and around 10 billion dollars LETES or government bills whose reimbursement has been suspended in December 2019.

Time is running short for Argentina to avoid an outright default on its debt contracted under foreign law – the most difficult to litigate – as it faces an incredibly huge amount of debt amortization payments and interest payments over the next two years (cf. the charts and table below).

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What could the forthcoming restructuring of Argentina’s debt look like ? 

Argentina’s 100 billion dollars default in 2001 was followed by a long negotiation and litigation process with foreign private investors before the majority of those investors accepted a 70% haircut on the nominal price of that debt.  However, a minority of investors – the so-called “holdouts” which included mostly US-based hedge funds which bought the defaulted bonds at a deeply discounted value immediately after the default, refused that settlement. These holdouts sued the Argentinian government in courts and attempted to seize Argentinian assets located abroad. In February 2016, the Macri government eventually reached a settlement with the remaining holdouts,  among which figured the hedge fund Elliott Management run by veteran investor and industry legend Paul Singer.

Drawing lessons from Argentina and Greece, which also faced contentious relations with some holders of its debt issued under foreign law, the IMF, the IIF and other international financial bodies, alongside representatives of the G20 countries, engaged a collective effort to overhaul the restructuring clauses associated to sovereign notes. As a result of this effort, new “collective action clauses” (CVCs) were drafted in 2014 by the International Capital Markets Association (ICMA), an industry standard-setting  body. As pointed out by Gregory Makoff and Robert Khan, it was a victory for self-regulation proponents, as the alternative of building a comprehensive Chapter 11 – style bankruptcy regime, which would legally prevent the apparition of holdout creditors, did not reach the necessary consensus among all the involved governments, international institutions and market participants.

Nevertheless, three important points have been introduced by ICMA as part of the new standard CVC clauses to be included in forthcoming sovereign bond contracts :

  1. New majority and supermajority rules : An issuer could poll holders across different bond series according to a “two limb” vote. The required thresholds to restructure a sovereign bond would amount to two thirds of bondholders across all the multiple series, and a simple majority of 50% of bondholders for each series. In addition, a “single limb” mechanism can be used to aggregate all bondholders across multiples series and initiate a debt restructuring provided there is a 75% supermajority, regardless of the proportion of potential holdouts on each individual series.
  2. Reasonable protection of minority investors. Any restructuring accord reached with some investors has to be “uniformly applicable” to all other investors in case a “single limb” mechanism is actioned.
  3. More limited pari passu rules. The previous pari passu rules prevented creditors who agreed to take part to a restructuring of being paid before the holdout creditors were paid, which delayed the process for years and led Argentina to a technical default on its debt in 2014. The updated pari passu clause drafted by ICMA states that the debtor is not required to make simultaneous or equal payments to different groups of investors.

From a macroeconomic perspective, restoring the sustainability of Argentina’s sovereign debt will require not only a reprofiling of the debt obligations, by extending the maturities of the bonds with the shorter maturities. It will also require a haircut on the associated principal and on the coupons.

As per @GeneralTheorist

If the IMF and Argentine authorities want to achieve long lasting sustainability allowing the IMF to be on a disengagement path by mid-2020s, in time for the next election, without the re-emergence of external financing pressures, then a far greater contribution than a 4Y reprofiling and modest coupon haircut is needed by non-resident creditors. The importance of not ending up in a prolonged engagement with Argentina, given the relations between the two, means getting this right at this early stage of the new administration.

In analyzing the sustainability of the restructured debt and the odds that it will set back the country on a sound standing, it is of paramount important to consider both external, monetary and fiscal sustainability and the interactions between these three macro dimensions. These dimensions are too often considered separately. For example, the IMF uses two distinct analytical modules, one called EBA focusing on the external financing needs and one called DSA focusing on the government financing needs. Monetary sustainability is not a dimension that is considered per se by the Fund. The analysis should also evolve toward stochastic frameworks – with relevant assumptions on the joint distributions of the different macro variables –  away from the current mostly deterministic frameworks. The use of reduced form macro models in a stochastic context seems a good compromise between intractable DSGE models and deterministic models. It should be remembered that any model has its own shortcomings, especially given the general inability of most macro models to account for “sudden stops” and other episodes of hightened risk aversion and volatility. To account for the latter the joint distributions of the macro variables should accommodate these “fat tails” in a meaningful manner.

From the legal perspective, the “uniformly applicable” principle does not mean that all outstanding debt instruments should be treated equally by providing the same haircut on the Net Present Vallue (NPV) of a given debt security. It rather means that all investors should be offered an equivalent menu of options from which they can choose in order to convert the existing securities into new ones.

As per Sebastian Grund from the Columbia Law School :

Generally speaking, the uniform applicability concept does not require equal Net Present Value (NPV) reductions but rather that investors be offered (i) the same new instruments or (ii) new instruments from an identical menu of voting options. Ultimately, calibrating the uniformly applicable requirement in a litigation-proof fashion will be the crux any Argentine debt workout operation.

Alongside the aforementioned “single limb” mechanism, the issuer has the option to form two groups of creditors, one for shorter-dated bonds and another one for longer-dated bonds. This is probably what lies ahead for Argentina’s creditors given its front-loaded debt amortization schedule, which requires much deeper haircuts for shorter-dated bonds, perhaps with sweeteners such as GDP-linked coupons delivering additional payouts whenever the country’s growth performance improves.

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