From Poor Economy to Debt Default

A sovereign debt default occurs when a country does not meet a debt payment (principal or interest), i.e., it fails to meet the terms of a contractual agreement. A country that repudiates its debt faces the threat of sanctions such as loss of access to short-term trade credits, trade sanctions, seizure of assets, etc. In practice, however, the observed punishment does not correspond to what some might think. It may be noted that whereas domestic loans are supported by substantial collateral, the assets that can be appropriated in the event of sovereign country's default are often negligible. International experience suggests that defaulting governments have seldom been punished, either with direct sanctions or with discriminatory denial of credit. Countries try to avoid default not because of the collateral damage associated with default but because of the country's reputation. A country's incentive to make loan repayments is to preserve its future access to international credit and trade. Moreover, defaulting on sovereign debt may undermine the country's capacity to obtain beneficial deals in multilateral organizations. A default thus can have lasting effects on the country's growth, trade and the financial sector.

Why do then countries default? Studies distinguish three different causes: (a) liquidity problem (only a cash flow problem); (b) sustainability problem (the country may never be able to service its debt out of its own resources); and (c) unwillingness to pay (a country decides to stop paying it well before it is insolvent). Ultimately the decision of defaulting however, resides in the political sphere. The cheerful celebration of the December 2001 Argentine default by its Congress certainly suggests that losses for the defaulter were not big enough. Some studies indeed show that the welfare effects of the default are unambiguous: on the one hand there are output contractions and financial crises; on the other hand it alleviates the fiscal situation because debt payment falls. Why do, then, markets lend to countries that defaulted? An explanation is found in the procyclical nature of capital markets that lent vast sums to emerging markets in boom periods (associated with low returns in industrialized countries). In fact, it may be argued that lenders are paid accordingly for the risk they take. However, it is this same process that produces “sudden stops” in borrowing countries, and that triggers default episodes. Sometimes there is “excusable default” defined as a default triggered by bad shocks. In such a case, both creditors and debtors have incentives to renegotiate, and it is optimal to have a debt relief (or partial default) than a total disruption of debt. The incentives of lenders and borrowers to reschedule or restructure debt obligations are quite different. The incentive for lenders is to recover as much possible value of defaulted debt (provided that the penalty, in terms of seizure of assets, is much smaller than the amount defaulted). The incentive from the borrowers' view point is to minimize the output and other economic costs of a default.

Historical evidence suggests that countries that have defaulted on their external debts have done so repeatedly. Including the recent episode, Argentina has defaulted 5 times since 1824. This is not an exclusive characteristic of Argentina provided that other countries in the region have defaulted on a similar number of occasions. For instance, Brazil and Colombia have defaulted 7 times while Venezuela 9 times. If this historical account tells anything is that defaulting is not new. However, the latest Argentine's default of 2001 has some distinctive characteristic that puts it in the Guiness Book of World Records of the default history: it was the largest in the history of international bonds with over $82 billion. Argentine Debt Default Background: During most part of the early 1990s, Argentina outperformed most other countries in Latin America in terms of economic growth. However, in the late 1990s, due to the decision to peg its currency to the U.S.Dollar, pro-cyclical fiscal policies and extensive foreign borrowing left Argentine unable to deal with a number of global economic shocks. This ultimately led to the outburst of a severe currency, sovereign debt and banking crises. To understand the causes of crises, few important background events are in order. As government spending could not be matched by taxation and financial market borrowing, the authorities became dependent on inflation to finance the rising deficits (known as inflation tax, seigniorage). This led to a sharp rise in inflation (hyperinflation). By 1989, inflation reached to an annual rate of 3,080 %. Political support to deal with hyperinflation once-and-for-all grew.

The government introduced radical economic reforms in line with the dictate of the Washington Consensus. Beside others, the reforms included the privatization of state-owned enterprises, deregulation of the economy, reduction in trade restrictions, etc. With the implementation of these reforms, Argentina won great admiration from all international finance institutions, especially from the IMF. On the Wall Street, Argentina had become one of the most favourite emerging market; the country was able to borrow relatively cheap in U.S. Dollars and thus became the biggest issuer of emerging markets debt in the late 1990s. This made the country increasingly dependent on foreign capital. Earlier in 1991, to tackle hyperinflation, Argentina also introduced a Currency Board (the so-called Convertibilidad). The Convertibilidad acted like a monetary authority, which was required to maintain a fixed exchange rate with a foreign currency. This policy objective required the conventional objectives of the Central Bank to be subordinated to the exchange rate target. Among its major features were; (1) the introduction of a new currency, the peso (which amounted 10,000 Australes), which was set at an exchange rate of one peso to one U.S. dollar, and which was perfectly convertible and; (2) a new law was introduced, which permitted the Central Bank to issue new pesos only against new foreign exchange reserves. The Convertibilidad had many aspects of a dollarization: contracts made in dollars acquired the same status as those made in the local currency (including bank deposits and credits).

The Convertibilidad laid the foundation for (temporary) exchange rate stabilization. Argentines could now freely convert their pesos into dollars. Since then bank deposits and loans in dollar became widespread. After the implementation of these reforms, the Argentina economy entered a period of economic growth between 1991 and 1997. Under the Convertibilidad regime – inflation came to an end, there was an initial period of high growth rates, and there was a substantial surge in capital inflows. This new regime did not prohibit the state from having budget deficits. However, such deficits could not be financed by the Central Bank, but only through borrowing. Much of the latter consisted of foreign borrowing. The public sector continued to be in deficit due to: (1) the payments of the debt services, which grew from approximately 4% of the GDP around 1993 to more than 10% by the end of the decade and; (2) the need to finance the social security system with pesos, as most of the young taxpayers had transferred to the private system. In 1994, the Argentine government partially privatized the public pay-as-you-go social security system that had been in existence since 1967. This decision was strongly promoted and supported by the World Bank and the IMF and had a major impact on Argentina's fiscal accounts. The loss of revenue, plus accumulated interest costs, amounted to nearly the entire government budget deficit in 2001. As a side-effect of the Convertibilidad, the Argentine economy was especially vulnerable to foreign crises. The outbreak of currency crises in Asia, Russia and Brazil in 1997 caused capital to flow out and the Brazilian devaluation made the trade deficit worse. As Dollars were flowing out of the Currency Board, the decline of the Dollar reserves reduced the money supply and raised interest rates. Moreover, the currency crises raised the cost of borrowing for emerging markets. Brazilian devaluation reduced the competitiveness of Argentine producers. Meanwhile, the prices of Argentina's agricultural export products fell. All this led to a sharp reduction in exports, which caused sharp rise in current account deficit that pushed the country into recession.

The growth rate of Argentina's GDP began to slow down in 1998 and in 1999 it began to experience a negative growth rate, which continued until 2003. The most pronounced decline occurred in 2001 and 2002, when the country experienced the collapse of the Convertibilidad system. This decline in growth also produced dramatic increases in poverty. For instance, unemployment grew from 13.2% in 1998 to 21.5% in 2002; the proportion of the population living below the poverty line grew from 35.9% in 1998 to 57.5% in 2002. Moreover, the rate of investment, which was already declining in the late 1990s, took a plunge from 1999 on, dropping from 19.1 % of GDP to 11.3 % in 2002. By the time of De la Rua's government (December 1999 to December 2001), there was a consensus among economists that devaluation was imperative. Policymakers hesitated due to devaluation's perceived financial and political risks involved and the De la Rua's government adhered to the view that the main problem was not the exchange rate overvaluation but fiscal deficit. This view led the government to have a tight fiscal policy with the expectation that fiscal adjustment would entail lower risk premiums and consequently interest rates, which in turn would reduce the debt service payments, one of the principal components of the public expenditure. However, these policies reinforced the recessionary trend and undermined market confidence in the viability of the Convertibilidad.

Argentina kept on maintaining its peg with U.S. Dollar, which left it unable to respond to the growing economic problems, as it could not apply monetary policy under fixed exchange rate regime. In fact, when U.S. Dollar appreciated (between 2000 and 2002), its highest level in 15 years, the peso became overvalued. Moreover, the exchange rate peg was not supported by nominal price and wage flexibility which further reduced Argentina's instruments to deal with currency overvaluation and decreased the credibility of the exchange rate regime. As foreign investors lost their confidence in the Argentina economy, it had to face increase in cost of borrowing. Consequently, the country virtually lost its access to the international financial markets in July 2001. By the second half of 2001, the public began to fear the possibility of devaluation and there was increasing speculation against the peso. The situation was worsened by a unique feature of the Convertibilidad. In particular, local banks were able to offer deposits in foreign currency to the general public, and the Central Bank guaranteed that these were secured. Therefore, the peso speculation converted into a bank run, as the public withdrew their savings from foreign based accounts into cash.

In order to sustain the Convertibilidad, the government established severe restrictions on capital movements and cash withdrawals from banks in December 2001. This measure infuriated the general public and produced massive social unrest and political turmoil. To avoid a massive peso withdrawal from the banks the government declared a bank holiday on December 20th, which lasted until January 3rd, 2002. The collapse of the De la Rua's government and the successive governments led to the abandonment of the Convertibilidad. Argentina abandoned its Convertibilidad in January 2002 after a severe recession. To some, this emphasized the fact that the currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. However, Argentina's system was not an orthodox currency board, as it did not strictly follow currency board rules – a fact which many see as the true cause of its collapse. They argue that Argentina's monetary system was an inconsistent mixture of currency board and central banking elements. It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government's decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year.

The new government of Duhalde (2002-2003) decided to compulsively convert foreign-currency bank deposits into pesos at a rate of 1.4 pesos per dollar when the market rate was 2 and even reached 4 pesos per dollar. Additionally, to avoid a generalized bankruptcy bank credits in dollars were converted at a rate of one-to-one rate. On December 24th the service payments of a significant part of the public debt were suspended (it initially affected $61.8 billion in public bonds and $8 billion in other debt instruments). It did not include debt contracted with multilateral institutions (such as the IMF, the World Bank and the Inter-American Development Bank) of about $32.4 billion and guaranteed loans of $42.3 billion. This turned out to be the largest default in Latin American economic history, as the foreign private debt amounted to $ 82 billion out of $ 153 billion. Besides, the extra premium paid by Argentine bonds significantly influenced the Menem (1989-1999) and De la Rua's governments' decisions. As financial markets disbelieved the country's capacity to repay its foreign debt, those governments introduced tighter fiscal policies. However, following the contractionary policies, markets offered a higher discount on those bonds, which in fact worsened the country's financial situation. As expected, the default followed. How did then the 2001-2002 Argentinean default impact it?

• Immediate Sanctions: The value of Argentine's foreign assets was very small compared to its foreign debt. Threat of sanctions and seizure of assets occurred only rarely. Some of its bondholders tried to take legal actions in the courts of New York to attach Argentinean Central Bank funds in the New York Federal Reserve. However, it proved difficult for them to convince the courts. The latter held that since Argentinean funds belonged to Argentina's Central Bank, which was considered an entity separate from the Argentinean government, the claims had to be denied.

• Future Sanctions: Another type of sanction is the loss of access to international credit. It may be noted that the amount of credit declined dramatically in 2001 and reached a low point in 2005 (there is no information for 2002 to 2004 because the country was in total default and there were no financial operations). Credit began to flow in again in 2005 and by 2006 reaching the levels of 1994-95. Thus, these types of sanctions were of short durations.

Interestingly, net foreign credit to Argentina began to decline before the default. Net foreign portfolio investment dropped from U.S$ 11.5 billion in 1998 to U.S$ 8.7 billion in 1999 and to U.S$ 6.8 billion in 2000. Although, the decline in 2002 can be interpreted as reflecting the default, this is not the case of the previous years. Thus, the decline in the inflow of portfolio investment cannot be solely blamed in the default, but rather on the deterioration of the economic situation and especially the increased evidence of the lack of sustainability of the Convertibilidad. It must be underscored that the end of the Convertibilidad entirely changes the dependence of Argentina on foreign capital. During the 1990s, the emission of debt was mainly associated with the necessity of acquiring foreign reserves to maintain the currency board and the payment of interest. After 2002, both conditions disappeared, and this gave the Argentine government more room to negotiate.
• Immediate Effects: Aerolíneas Argentinas was one of the most affected Argentine companies, cancelling all international flights for various days in 2002. The airline came close to bankruptcy, but survived. Several thousand newly homeless and jobless Argentines found work as cartoneros, or cardboard collectors. An estimate in 2003 put the number of people scavenging the streets for cardboard to sell to recycling plants at 30,000 to 40,000 people. Such desperate measures were common given the unemployment rate of nearly 25%.

Argentine agricultural products were rejected in some international markets, for fear they might arrive damaged by the chaos. The United States Department of Agriculture put restrictions on Argentine food and drug exports.
• Impact on Growth and Trade: The default had little impact on either growth or trade. The dramatic decline of growth in the years 2001-02 was a direct consequence of the collapse of the currency board, and it can be claimed that the default was the result of the crisis rather than the cause of it. The default may not be separated from the deep economic recession and regime's collapse, and therefore its specific contribution may be difficult to quantify.

In addition, the resumption of spectacular rates of growth in 2003 had little to do with the default. As far as trade is concerned, exports stayed at about the same level in the years 1997-2002, while dramatically rising in the years 2003-2006. As far as imports are concerned, their decline began in 1998, plunging in 2002, but recovered rapidly after 2003. Import declines cannot be explained by a lack of credit related to the default, but rather by the dramatic decline of the GDP, the decline of investments and the spurt in import prices due to the devaluation of the currency.
• Impact on the Banking Sector: The contraction of the economy in 1998 resulted in rising non-performing loans. The January 2002 economic reforms, including the abandoning of the Convertibility Board, the pesofication of bank deposits and loans at two different exchange rates caused a wave of defaults and liquidity problems for companies. The default rate of rated issuers was as high as 60%. The apparent solid position of the banking sector could not prevent the sector, including both domestic and foreign banks, from being affected by the crisis too. Amongst others, Argentina's largest privately owned bank, Banco Galicia, and several foreign banks such as the Bank of America, CitiGroup, FleetBoston and J.P. Morgan Chase & Co suffered heavy losses.

• Foreign Direct Investment (FDI): The default did not reduce FDI, which was a feared consequence. Even in the worse time of the crisis, that is 2002, FDI, though substantially lower, never disappeared. Also, the collapse of the financial system should certainly not be attributed to the default but to the non-sustainability of the Convertibilidad. The internal financial system recovered very fast after the new macroeconomic equilibrium was put into place.

• Recovery from Crisis: Negotiations with bondholders, which began in 2002, dragged on until June 2005, when President Kirchner made an offer which consisted of the exchange of old bonds for new ones. The new bonds amounted to 25% of the value of the old debt. Kirchner made it clear that this offer was not negotiable and he gave bondholders one month to accept or reject the offer.

Within that time 76% of the bondholders accepted the offer. The remaining 24% were not repaid and kept on trying to regain their investment through foreign legal actions. The unilateral offer was indirectly supported by other actors' inaction and lack of initiative, together with extraordinarily good international conditions. Both the IMF and developed countries' governments adopted a laissez-faire approach to the sovereign crisis resolution. Moreover, the low interest rates in the United States, and the narrowing of emerging bond spreads improved the conditions of the offer. The government also took for granted the position of local financial investors (mostly retirement and pension administrators who were obliged to invest a certain proportion of their capital in public bonds), which provided a “floor of acceptance” of about 30%. The default itself eliminated one of the principal components of the public deficit, that is, the need to pay huge sums as interest on the debt, and by 2002 the prices of the Argentinean exports were rising dramatically.

Argentina's recovery from the economic crises was indeed due, mainly, to the improvement in the trade balance. It went from being negative in the late 1990s to a surplus in 2000, and this surplus rose dramatically in the subsequent years. The surplus was the result of two factors: (i) the country's exports, which hardly ever declined, rose substantially, as a result of both a strong world demand for the country's products, and also the substantial devaluation of the peso; and (ii) there was a dramatic decline of imports, due to both the rise of poverty levels and the decline of investments. Overall the collapse of the Argentine's financial system did not have any significant effect on international trade. The fact that there were no disruptions after the default may be explained by the fact that Argentine's exports were concentrated on traditional agricultural markets and primary goods with well-established financial services and prices on the rise, or tied to the Mercosur with politically managed quotas. The strong growth of exports also strengthened the finances of the government, as the major export items were taxed. In fact, the government's budget had a surplus from 2003 on. However, as in the case of government revenues, the level of expenditures also expanded, which, in turn, contributed to economic expansion.

The devaluation of the currency after loan default did not produce an immediate rise in the level of prices, mostly due to the existing high unemployment rate and to the freeze of public utilities' prices and other price controls introduced by the Duhalde and (mainly) Kirchner (2003-2007) governments. Economic recovery was attributed to the achievement of a new macroeconomic equilibrium. Those authors stress that the policies implemented were different from those common in the 1990s. In particular the new governments imposed new exchange rules that compelled exporters to liquidate dollars in the local market and imposed capital controls. In fact these measures were so successful that the Central Bank was compelled to absorb the excess of foreign currency to avoid the appreciation of the peso.

• Lessons for Emerging Economies: Argentina crises were due, mainly, to internal problems: the lack of an internal adjustment to accompany the Convertibilidad, which led to an unsustainable external debt situation. The default was a “way out” and Argentina got away with it due to the favourable external conditions, leading to huge trade surpluses, which led to growth and the growth, in turn, led to a softening of the country's bad reputation in global financial markets. The default thus could certainly not have been declared at a better time. Also, the fact that Argentina was smart enough not to default with the multilateral institutions was crucial because this line of credit remained open and the Argentine government made the announcement regarding the debt restructuring.

• Was the Argentina default really necessary? Evidence shows that default dramatically alleviated the government's burden, as debt servicing as a proportion of total government expenditures declined to 9.2% in 2004. However, the servicing of the debt might have been quite manageable in an expansionary period.

The fact that the default was done in a climate of political turmoil, mostly as a reaction to the failure of the policies implemented in the previous decade showed that the default was an immediate necessity rather than an unwillingness to recognize the debt. It was celebrated by the Congress as a political triumph with the expectation that it was necessary to avoid further macroeconomic restrictions. In a framework of fiscal, financial and political crisis, defaulting on foreign creditors was a short-term fiscal alleviation whose consequences would be the responsibility of an unknown future government.

All in all, two important points need to be made that are special features of the Argentine case. First, Argentina faced several favourable conditions in the aftermath of the 2002 economic crisis. The abandonment of the Convertibilidad alleviated the government's dependence on foreign capital and placed the country on a positive growth path that lasted several years. Moreover, the country's terms of trade entered in a favourable phase, which significantly contributed to the economic growth. Second, the default was declared concomitantly with a catastrophic economic, political and social crisis reduced its significance and it made multilateral institutions more sympathetic to the Argentine government debt restructuring process. Many analysts thought default would lead Argentina into a long period of stagnation and would keep it outside the world's financial markets for a long period of time. This did not occur! Argentina's experience indeed corroborates the historical fact that many, if not all, defaulters “get away with it.”

Argentina default was caused by the undesirable convergence of several economic events: a hard currency peg, currency overvaluation, economic rigidities, inappropriate fiscal policy, external shocks, large scale foreign currency borrowing followed by a “sudden stop” in capital inflows and continuing support of IMF played an important role in the course of crises. This together with the political and social turmoil that accompanied the events made the Argentine crisis one of the most severe emerging market crises in history. As world economic growth in the early 2000s was strong, Argentine producers benefited from the strong depreciation of its currency. The Argentine economy was able to recover rather quickly. Nevertheless, deep structural reforms were never implemented.

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad. [email protected]

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