On the economic, political and legal ramifications

The single seat at the press conference said it all.

Argentine Finance Minister Axel Kicillof would be speaking alone. He would not be accompanied by court-appointed mediator Daniel Pollack, or with representatives of holdout firms.

There would be no deal.

Without one, New York banks could not legally process Argentina’s payments to the vast majority of its creditors. That put Argentina in the extraordinary position of being solvent and willing to pay, yet in default.

The saga that began in 2001, when Argentina executed the largest-ever sovereign default, would continue. Since that crisis, Argentina had successfully restructured 92 percent of its outstanding debt. The country paid these holders more than US$190 billion in principal and interest in the last ten years.

But the remaining eight percent—typically large hedge funds—refused the restructuring. Instead, they initiated a lengthy legal battle demanding that Argentina pay the full nominal value of the bonds. The strategy paid off in 2012 when a New York Second Circuit Court ruled any further payment on restructured debt, without honoring holdout debt, illegal.

Argentina appealed the decision to the US Supreme Court, but it refused to hear the case. This put Argentina on the hot seat. Its next round of interest payments on the restructured debt was due June 30, with a 30-day grace period.

That expired as Minister Kicillof took his seat for the press conference and, for the second time in 13 years, Argentina was in default.

The minister took a hardline in his press conference, but this may have just been posturing. Rumors of arrangements between the Argentine Association of Private Banks (ADEBA), major investment banks, and the holdouts continue to swirl. The markets appear to be keeping faith that a solution is near: despite a rough day on the Argentine stock market, yields on the country’s bonds did not rise dramatically.

As it stands now, nobody wins. Argentina is in default, no one is getting paid, and the eight-percent holdouts have exhausted their biggest trump card—the threat of putting Argentina into default—without extracting anything tangible from Buenos Aires.

The Economic Consequences: A Simmer, not a Boil

As Argentina knows all too well, sovereign default often precipitates economic disaster. In 2001 crisis, the country chewed through three presidents in two weeks, and violent protests shook the streets of Buenos Aires. Millions of Argentines lost their life savings as the peso plummeted against the dollar.

By contrast, the reaction to the current default will likely be muted. Typically, punishment for countries in default includes losing access to international markets as well as lengthy and costly litigation with creditors. But Argentina lacked access to international markets since 2001, and the government knows the well-trodden path to the courthouse.

The default will likely stoke inflation and capital flight, but Argentina already faced these macroeconomic pressures prior to the current standoff. Whereas the 2001 default had significant contagion risk because so many ordinary investors held Argentine sovereigns, in this case the notes are mostly held by hedge funds. Potential spillover is limited.

Argentina will certainly face economic ramifications. The federal government may already be unable to access international markets, but Argentine firms still can. Private firms, as well as sub-sovereigns are likely to face punishing borrowing costs—something that could hamper the country’s efforts to develop energy infrastructure.

Assuming the crisis is resolved by (at the latest) 2015 following the expiration of the RUFO clause, these negative effects will be felt, but they will be short-lived.

Even a settlement, however, would not necessarily have been good news. Argentina could have faced solvency issues. The holdouts estimate that Argentina would owe an additional US$7.5 billion. The Argentine government estimates that it would owe an additional US$15 billion. Either way, it would be a tall order for a country with, at best, roughly US$30 billion total in international reserves.

Moreover, any settlement could have triggered the now infamous Rights Upon Future Offers (RUFO) clause written into the restructured debt. This clause entitles those that accepted a haircut “equal treatment” should Argentina voluntarily agree to pay holdouts at a better rate.

Had Argentina satisfied the holdouts’ demands, restructured creditors could theoretically activate this clause, thus putting Argentina on the hook for upwards of half a trillion dollars. The RUFO clause expires on January 1, 2015, and Argentina requested a stay on the Judge Griesa verdict until the New Year. The request for a stay was rejected.

Some analysts have insinuated that the emphasis on RUFO is a ploy by the Argentines to buy time. They suggest that the courts would not interpret capitulation to the holdouts as “voluntary” and anyway, they claim, restructured creditors would be unlikely to exercise the RUFO clause. Yet Argentine apprehension is not unfounded. After all, Judge Griesa’s novel ruling on pari passu was unexpected, unprecedented and unsupported by key international institutions such as the International Monetary Fund. Argentina could ill afford risking a similarly controversial ruling on the RUFO clause.

The Political Consequences: Las Bonistas No Son Argentinas

Often, governments that steer their country into economic crisis face severe political reckoning at home. Yet even as President Cristina Kirchner’s domestic popularity wanes, the inability to reach a deal with holdouts is unlikely to spark a political backlash. While Argentines are generally anxious to shed their reputation as economic pariahs, capitulation to the so-called “fundos buitres” (vulture funds) would be a tough pill to swallow.

The holdouts consist mostly of hedge funds that purchased Argentine debt in the months leading up to the country’s catastrophic 2001 default, and especially in the months after the default. For the most part, these funds never truly invested in Argentina. Rather, they scooped up the notes on the second hand market at steeply discounted prices with the explicit intent of eventually taking the case to court and forcing Argentina to pay full nominal values.

From the Argentine perspective, these funds seek to capitalize richly on Argentina’s most harrowing national crisis of the last 20 years, at the direct expense of the current Argentine government. According to Buenos Aires, if holdouts had accepted the 2005 or 2010 restructurings, they would have garnered 300 percent profit. As it stands, they are holding out for 1600 percent profit.

Considering that it is a North American judge in a New York courtroom enforcing the ruling, President Kirchner will not struggle to portray Argentina as the victim of high finance. If anything, Minister Kiciloff’s confident, stout and ultimately very Argentine performance could be a much needed boon back home for the Kirchner administration.

Legal Implications: Advantage Creditors

The consequences of Judge Griesa’s ruling could reverberate well beyond Buenos Aires as the case could represent a watermark victory for creditors’ rights. Countries under severe economic duress often rely on “haircuts” in order to manage a structured default, and ultimately, to emerge from crisis. This strategy is contingent upon creditor’s accepting a loss. For example, in 2012, Greece executed a bond exchange program that offered 34 cents on the dollar—a program viewed as vital to that countries painstaking return to normalcy.

Creditors may now be reluctant to accept a write-down if they believe they can hold out for full payment. Even if retail creditors could never mount the litigation efforts of hedge funds, the ruling would seem to encourage firms that specialize in amassing distressed debt on the secondary market with no intention of restructuring.

On the other hand, if the global financial community determines that such behavior is counterproductive, the ruling could fast-track efforts to prevent similarly situations in the future. Some argue that the answer lies in collective action clauses that allow a super majority of bondholders to enforce restructuring for all holders of a given set of bonds.

Of course, given the precedent set by Judge Griesa, the supermajority may be tougher to reach.

Moving Forward

The true shame of these recent developments is that Argentina will continue to be an economic outcast. The country has been roundly criticized for manipulating economic data, cooking the books, and for exercising a heavy hand on the country’s finances. Part of this is due to short-sighted governance. But part of it is also due to Argentina’s inability to access international credit. Because it cannot finance a significant deficit, Buenos Aires has overvalued its currency while implementing capital controls and limiting imports.

The latest default will not radically alter the Argentina’s status-quo, but Argentina’s status-quo was not so hot to begin with. Ultimately, the country remains unable to rejoin the global financial community until it resolves the lingering effects of the 2001 crisis.

Samuel George is a Latin America specialist working in Washington-DC

Also by Sam: The Gringo’s Guide to the Argentine Holdout Crisis & Argentina’s Day In Court