Preventing the Next Argentina

Investors, bankers, government officials, and academics are all scrambling to come up with fixes in hopes of preventing another debt fiasco like that of Argentina, but it likely won’t be in place by the time the next country goes belly-up.

This week the United Nations General Assembly weighed in with a resolution that was supported by an overwhelming majority of countries. China and a coalition of developing countries put it forward, but the United States, Germany, the United Kingdom, and Japan rejected it, illustrating one of many divides holding back efforts to change the system.

Argentina went into default for the eighth time at the end of July, after U.S. courts ruled that the government couldn’t continue paying bondholders who’d struck an earlier deal to accept less money without also paying holdout creditors. But default is not the end of the story.

President Cristina Fernández de Kirchner, who says the investors who took her government to court are "vultures," still has to find some sort of resolution. Her government tried to get bondholders to trade in their bonds under U.S. law for ones governed by local Argentine law, a move that gives the debtor government more control. An exchange would also allow Argentina to avoid the U.S. ruling, but government officials acknowledged this week that bondholders weren’t going for it. The rejection was expected because the switch would have significantly lessened investors’ bargaining power in the ongoing settlement negotiations.

Trade groups, the IMF, and now the U.N. are all trying to come up with a fix. The only problem is that they have vastly different ideas for what that should look like — making it increasingly unlikely that the chaotic current system will change in any meaningful way.

The scramble is an attempt to prevent a repeat of the chaos that erupted when a U.S. court ruled that the Argentine government couldn’t continue paying bondholders who’d struck an earlier deal to accept less money without also paying a holdout group of American investors 100 cents on the dollar. The ruling was a huge win for NML Capital, which had bought the bonds on the cheap, but infuriated Argentine officials like Kirchner.

Beyond the vitriol, the court decision brought new attention to the messy default process that’s currently in place for countries that can’t pay their debts. Fixing it is increasingly important for poverty-ridden countries like Grenada and the Democratic Republic of the Congo, both of which are fighting investors in U.S. courts who are hoping to use the NML ruling to boost their case for being paid back in full. Ukraine, whose already shaky finances have gotten even rockier during its standoff with Russia, could also need a way of persuading investors to take a "haircut." Under the current system, that won’t be easy.

Key powers at the United Nations are hoping to make it easier. Earlier this week, the U.N. General Assembly voted to put in place a new bankruptcy procedure for indebted countries that would create a global system for arbitrating debt disputes. The resolution called for an intergovernmental framework, but didn’t detail how it would work.

"The time has come to give a legal framework to the financial system for restructuring sovereign debt that respects the majority of creditors and which allows countries to come out of crises in a sustainable manner," Argentine Foreign Minister Hector Timerman said after the vote, according to Reuters.

The nonbinding U.N. resolution garnered 124 out of 193 votes and won support from China, which holds huge amounts of debt. Eleven countries, including the United States, voted against the measure. American officials said it would create uncertainty in markets that could make it more expensive for developing countries to borrow money.

"The fundamental problem is that the U.S./U.K. and other major money centers are not going to change their laws to subjugate themselves to rules from a multilateral body," Robert Kahn, a senior fellow at the Council on Foreign Relations, said in an email.

The IMF is also looking at possible ways to make the sovereign debt restructuring process less expensive and disruptive. The fund’s chief economist warned in late July that Argentina’s default could have ramifications for the global financial system.

"There is a cost to the world in the sense that we need resolution systems which work well when countries are in trouble and one of the implications of this Argentina episode is that there is much more uncertainty as to how we’ll be able to restructure debt for other countries in the future," IMF head economist Olivier Blanchard said.

The IMF started studying ways to reform the system in June, but hasn’t proposed anything specific. The IMF is unlikely to consider trying to create a supranational bankruptcy process, as the U.N. resolution calls for, without support from big economies like the United States, U.K., and Japan, which all voted against the U.N. proposal. The fund also tried to create a similar process called the Sovereign Debt Restructuring Mechanism in the early 2000s, but the idea was roundly rejected in 2003 for the reasons that Kahn stated.

So far, an industry-led proposal looks most likely to succeed. The International Capital Markets Association, a trade group for banks, brokers, and investors, based in Zurich, put forward new terms that could be incorporated into new bond contracts that would make it harder for a small group of investors to hold up the restructuring process.

Under the trade group’s plan, all bondholders would be obligated to go along with any deal that 75 percent of the group agreed to. That would mean holdout investors would be unable to sue the debtor for 100 cents on the dollar after a deal was finished, as happened with Argentina. Greece adopted similar terms for its new bonds after it defaulted on its debts during the European debt crisis in 2012 and had to negotiate with bondholders.

Eric LeCompte, a critic of the distressed-debt investors, or "vulture funds," said the private sector initiative was a step in the right direction, but wouldn’t solve all the problems developing countries face. He argues that poor countries need an international authority — like a bankruptcy court — that would determine who gets paid and how much, so that indebted governments don’t have to fight long, expensive legal battles.

"The [U.N.] vote illustrates that there is a supermajority of countries around the world that believe the current system is broken, and most countries also agree that the urgent fix is a bankruptcy process," said LeCompte, who is the executive director of Jubilee USA Network, a nonprofit organization that advocates debt forgiveness for developing countries.

The industry-led effort is likely the only one that will gain wide acceptance. Though it already counts the U.S. government among its supporters, it won’t be easy to implement any changes. The new framework will only be applied to new contracts, unless countries decide to try to exchange old bond contracts for new ones.

Consequently, efforts to come up with a new framework won’t do anything for countries currently in the crosshairs of bondholders. For example, hedge funds looking to collect on bank loans upwards of 20 years old are pursuing the DRC, which was then called Zaire. A New York district court ruled that the DRC must pay Themis Capital and Des Moines Investments a total of $69 million — $50 million of which is interest. Lawyers for the DRC are still fighting the case.

The private sector proposal also won’t help the next country that has to renegotiate its debts — whether it’s Ukraine or Angola. The IMF warned Ukraine last month that the current bailout wouldn’t be enough if fighting continues to drag on in the east. If the current cease-fire with Russia-backed separatists doesn’t hold, Ukraine will likely have to ask the IMF for more money or ask bondholders to accept a "haircut" (less than the promised amount) on their bonds.

At the same time, investors have been buying emerging-market bonds — in countries like Kenya, Ecuador, and Ivory Coast — like never before. The rush to invest in these risky markets has prompted concerns about overborrowing that could lead to a raft of defaults in the coming years. Nearly a quarter of countries with low ratings from credit rating firms default, according to Gabriel Sterne, head of global macro investor services at Oxford Economics Ltd. and a former IMF economist. Whichever country is next to run into trouble, for now, the government will have to take its chances with the same messy process.