Wednesday, August 27, 2014

How the US Supreme Court brought Argentina to the brink of financial crisis

Insert "Evita" joke here Charlie Diaz/Azcue

There was big news about Argentina from the United States Supreme Court yesterday. The justices declined to hear an appeal of a lower court ruling that had gone in favor of Paul Singer's hedge fund, Elliott Management.

The lower ruling is intended to force Argentina to pay a vast sum of money to Singer, but it's far from clear that it will have its intended effect. Instead the risk is that many other investors who are currently being paid by Argentina will lose their payments, and Argentina will be thrown into financial chaos.

What does Paul Singer want?

Money. Way back in 2002, Argentina defaulted on its debts and devalued its currency as part of a basically successful effort to get out of a massive depression. Once the situation had stabilized, Argentina began the process of trying to make amends with the international financial system. So it undertook a two-phase process — in 2005 and 2010 — of "restructuring" its debts, giving most bondholders some money in exchange for the bondholders giving up the claim to everything they were originally owed.

Not every bondholder accepted the deal. Singer's fund owns a large quantity of so-called "holdout" bonds — bonds that aren't part of the restructuring deal — and he's been trying to get foreign courts to act as his debt collection agency and make Argentina pay what he's owed.

What did the Supreme Court decide?

They didn't really decide anything. They merely declined to hear an appeal of a ruling previously made by the Second Circuit Court in New York. The Second Circuit cannot actually force Argentina to pay Elliott, since the Second Circuit is an American court and Argentina is a foreign country.

But much of the global financial system is located in New York, and this gave Elliott their opening. They secured a ruling that bars US-based financial institutions for facilitating payments between Argentina and the non-holdout bondholders, unless Argentina pays the holdouts as well. This disrupts the tidy arrangement that's prevailed since the original restructuring, where Argentina had obtained most of the benefits of a full default while still preserving some access to the global financial system.

Who benefits from this ruling?

It's not entirely clear. Of course if Elliott manages to get its money, then the company and its investors will win. Non-Argentina developing countries looking to borrow money abroad could also benefit, because the precedent would reduce the risk of future defaults which could make lenders more willing to hand over cash. On the other hand, it does not seem especially likely that Elliott will end up getting paid.

Who loses from this ruling?

Mostly Argentina, which is now in a very awkward position. It's not at all clear that Argentina even has the money available to pay Elliott if they wanted to — and they really don't want to.

But at the same time, defaulting on payments to the non-holdouts would further exacerbate the country's existing economic problems — further isolating it from the global financial system, further discouraging investment in Argentina, and further encouraging its citizens to find ways to squirrel money out of the country to someplace safer.

In addition, it's far from clear that making it easier for developing countries to go into debt is a good idea. Political leaders have a certain incentive to over-borrow since they may be out of office by the time the tab comes due. The fact that lenders need to worry they may not be repaid adds a dose of useful discipline to the process.

What options does Argentina have?

One option is to pay Elliott. This would be politically unthinkable for Argentine President Cristina Kirchner, whose entire political career has been built on the success of the 2002 default. It also would probably be economically infeasible, requiring the near-complete exhaustion of Argentina's foreign currency reserves.

Another option is to default, stop paying the renegotiated bonds, and tell the holders of those bonds to go complain to American judges if they don't like it. The risk is that even though this default would be involuntary, it could have similar consequences to a conventional default — scaring foreigners off of investing in the country and further damaging Argentina's currently weak economy.

The third option is to try to find a way to circumvent the American financial system while still paying the owners of the renegotiated bonds. Argentina's finance minister says he'll unveil a plan this afternoon — perhaps a plan to do just this. The consequences of any third way approach would, of course, depend on the details.

What are the larger implications?

As a literal legal matter, the implications of this case may not be large. Future bond contracts can always be written to include specific language designed to avoid some of the problems Argentina has faced.

As a less literal matter, the willingness of the judicial branch to take an ambiguous legal situation and resolve it in a way that favors the interests of a tiny number of hedge fund managers while violating the larger public interest could have implications for a range of future court cases. The ongoing controversy over Fannie Mae and Freddie Mac profits, for example, poses different legal issues but a similar basic political struggle where "vulture" investors want money that they don't seem clearly entitled to.

Why do these things keep happening in Argentina?

The Elliott vs. Argentina saga is a good illustration of how once a country starts down the path of debt problems and defaults, it can be hard to get off of it. It was earlier iterations of defaults that pushed the Argentine government in the 1990s to overcompensated by adopting a rigid peg of its currency to the dollar in order to get loans flowing again. And it was the rigidity of that currency peg that pushed Argentina into depression in the early-aughts.

The only way to end the depression was with the previous default, and the attempt to clean up the wreckage from that default brought Argentina into this litigation. At every step of the way the decision-making has made some sense, but rather than elevating Argentina out of its problems the country seems to get further caught in the cycle.

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