The long running Argentine debt-default saga has taken another step forward (or backwards, depending on your viewpoint). The US Supreme Court has ruled definitively against Argentina over 'sovereign immunity'. The ramifications, however, go far beyond Argentina.
Although sovereign debt restructuring falls outside the usual bankruptcy laws, a mix of formal and ad hoc processes have in the past facilitated some sort of resolution when countries are unable to repay. The Supreme Court's confirmation of earlier court decisions has brought informal voluntary resolution to an impasse.
Just as couples getting married do not typically plan for divorce and armies do not regularly practice retreats, financial contracts are made on the assumption that things will turn out well. But the existence of divorce and bankruptcy laws demonstrate that contracts do not always work out as hoped and the law must help to resolve the mess.
Sovereign debt contracts, however, have no clear legal resolution methods when the sovereign says it can't pay; sovereign immunity restricts the legal recourse of the creditor.
The US courts have lost patience with sovereign immunity. The plaintiffs, a vulture fund that bought Argentine debt cheaply after the majority of creditors agreed in 2005 to a restructure, can now use the normal methods of debt recovery (such as threatening seizure of Argentine assets anywhere in the world) in order to get a better deal, perhaps even full repayment.
In essence, the US courts have interpreted a 'boiler plate provision' of these contracts (the pari passu clause) as requiring a sovereign debtor to make full payment on a defaulted claim (in this case, held by the secondary market purchaser) if it makes any payments on the restructured bonds. As discussed in the 2013 Board paper, the Argentine decisions, if upheld, would likely give holdout creditors greater leverage and make the debt restructuring process more complicated for two reasons. First, by allowing holdouts to interrupt the flow of payments to creditors who have participated in the restructuring, the decisions would likely discourage creditors from participating in a voluntary restructuring. Second, by offering holdouts a mechanism to extract recovery outside a voluntary debt exchange, the decisions would increase the risk that holdouts will multiply and creditors who are otherwise inclined to agree to a restructuring may be less likely to do so due to inter-creditor equity concerns.
Other commentators have been more explicit on how unhelpful this court decision is:
This new regime is based on the idea that dealing with a defaulted sovereign will become so risky and expensive that it is simply not worth it. As a result, the country will become a financial pariah, unable to do basic financial business outside its borders. In sum, the decisions leave the prevailing system for sovereign debt management badly shaken.
It's understandable that Argentina gets little sympathy, and not just from the financial press (which is reporting all this with a tone of glee). The problem, however, lies in the implications beyond Argentina.
Just as individuals default, countries also reach a stage where they can't repay their debts in full. Simply insisting on the 'sanctity of contract' doesn't get us far in resolving the issues.
The debt problem is usually as much the fault of the creditor as the debtor. Remember all those euro-periphery bonds that were bought at yields almost the same as Germany's? Sitting down to reach a practicable resolution makes sense. When the clear majority of the creditors have done exactly that, those who come along afterwards to buy the 'hold-out' debt at a heavily-discounted price and then act as if they should be paid in full shouldn't be surprised if they earn the title of 'vultures'.
The damage is now done. Sovereign debt resolution can't be left in this unsatisfactory state. Europe provides many examples (Greece being the most prominent) of where the outstanding debt is clearly unsustainable and more restructuring is needed.
This presents a particular problem for the IMF. How can the IMF provide funds to rescue a stricken economy if these funds are then used to repay creditors who shouldn't have lent in the first place?
A restructure of private debt ('bailing in the creditors') has to be the prior step. The Fund has struggled manfully (actually it was Anne Krueger who did the heavy lifting) to come up with a sensible solution, only to be frustrated by the Wall Street proxies on the Fund's executive board.
Despite the large role played by sovereign debt in the 2008-2010 global financial crisis, this issue was not resolved consistently or satisfactorily. It's just possible that the dead-end of the US court decision may be the catalyst that gives the Fund the opportunity to get a sensible restructuring framework in place.
Originally published by The Lowy Institute publication The Interpreter. Republished with permission.