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Argentina Can't Pay What It Owes

By Charles W. Calomiris

Argentina is facing a sovereign-debt crisis. It avoided a debt restructuring last year with an International Monetary Fund-led rescue package in which debt holders were paid in full and invited to participate, at market prices, in new debt offerings. But that intervention did nothing to lessen the country's onerous debt burden. Now there is an urgent need to provide a permanent resolution to the problem. Further postponement of a debt restructuring is likely to increase the damage both locally and in other markets, notably in Brazil.

There is little doubt that Argentina is in over its head in debt. Interest and principal on the country's foreign-currency debts (which comprise 95% of total Argentine debt) must be paid for with net exports (exports less imports). With outstanding debt of $128 billion, and government-bond interest rates in double digits, even if Argentina reins in its fiscal deficit it will have to use more than half of its export earnings just to finance interest payments. This means imports would have to fall permanently by half for Argentina to repay its existing debt, or exports would have to increase by half. The adjustments necessary for imports to contract sufficiently are not politically feasible or economically desirable. Given the slow progress in trade liberalization and the current debt-laden environment, it is unlikely that exports can grow by half.

There are three reasons why an immediate restructuring is required.

First, restructuring will spur growth. Investors understand the arithmetic that requires a write-down and thus investor confidence would rise after the resolution of the current debt overhang (witness the flood of foreign-capital flows into Latin America after the Brady plan).

Second, the fallout from a debt write-down today would be small. Investors have been wary of Argentine debt for months and this has led to declining Argentine bond prices and a diversification of institutional investors' emerging-market positions away from Argentina. With prices already depressed, a write-down of 25%-30% of face value on Argentine obligations would produce a market-value decline of roughly 10%-15%.

This would not bankrupt Argentine banks, nor would it lead to a massive emerging-market debt sell-off. Sharp sell-offs occur when large, sudden losses force sales of risky assets as a means of reducing portfolio risk. But U.S. institutions are already "underweight" on Argentine debt. Although Argentina accounts for 25% of the J.P. Morgan Emerging Markets Bond Index+ (EMBI+), the typical weight in pension and mutual-fund portfolios is now 10%-15%. And the Argentine debt positions at hedge funds and proprietary desks of U.S. banks haven't been established through heavy borrowing, further limiting selling pressure.

On the other hand, postponing Argentine debt resolution for a year would increase the risk of substantial spillover effects to Brazil, a market that tracks Argentina and faces both its own large debt problems and election year instability in 2002.

Third, postponement--especially if orchestrated by the U.S. Treasury or the IMF--could lead to undue confidence about Argentine debt's long-term prospects. Today's debt problem is partly the result of past IMF-induced optimism on the part of creditors. Bond-price reflation would make a future debt write-down more painful for global capital markets.

A "good" restructuring is speedy and simple, and is perceived as fair and permanent. A 25%-30% across-the-board write-down on its privately held debt, with a new cash-flow structure that shifts (backloads) coupons to relieve immediate debt-servicing costs would meet those standards.

Experience in Ecuador and other nations that have undertaken a restructuring suggests that a combination of inducements for creditors could produce a speedy process--say, in three to six months. Helpful negative inducements include "exit consents" (changes in the contractual features of the old debt, passed by a simple majority vote of debt holders), which reduce the attractiveness of holding old debt and provide a powerful antidote to holdouts. Positive inducements include warrants and bonuses attached to new debts, which offer "upside" sharing in gains for creditors. To speed the process, rather than negotiating formally with a creditors' committee, the government could appoint a small consulting committee to advise it on how best to set the terms for exchanging old debt for new.

But thinking will have to change before there is a restructuring. Potential spillover effects are overestimated, and risks of postponement are underestimated. In recent crises, contagion effects have been traceable to the mechanics of selling pressure (as in the fallout from Russia's crisis), or to links across countries in import and export markets (as during the Asian crisis). Neither of these is important in the Argentine case, yet unwarranted fears of contagion have been stirred up.

There is wide agreement that Argentina must avoid currency devaluation. When balance sheets are dollarized, as in Argentina, devaluation produces financial distress and depression. The Indonesian financial collapse is a good example. But it is wrong to conclude that if Argentina defaults, it will not be possible for it to maintain its convertibility law, which requires the central bank to hold dollar reserves to back up issued pesos. Debt restructuring will reduce fiscal pressure on Argentina and, if accompanied by fiscal and trade reform, improve its profile as a place to invest. Those reforms will be more politically feasible if domestic pain is shared with foreign creditors. This means that fears of long-run capital flight are unwarranted.

Still, the effect of a debt write-down on capital flight immediately after default is worrisome. Recent actions by the Argentine government--the lowering of bank reserve requirements, the weakening of rules on dollar backing for the peso, and increased placement of government debt in the banking system--have exacerbated the potential risk of a liquidity crisis.

Here the IMF has a role. It should stand firmly behind the central bank and the convertibility law, and make liquidity assistance available as needed to restore confidence in the peso. That, after all, is what the founders of the IMF envisioned as its primary role. In contrast, bailing out Argentina through expanded long-term multilateral lending or U.S.-government assistance would lead to a failure to deal with the debt problem. That would postpone Argentine recovery and make any future restructuring much more difficult.

Charles W. Calomiris is a visiting scholar at AEI.

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