Making Argentina’s Debt Debacle a Rarity

The epic battle between Argentina and a group of U.S. hedge funds illustrates a fundamental flaw in the sovereign bond market: There's no orderly, well-established way for financially troubled governments to get relief from their creditors.

By: Date: October 29, 2014 Topic: Banking and capital markets

United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default

After defaulting on its debt in January 2002, the Argentine government wore down its bondholders into accepting a 75 percent reduction on their claims. Among the few who refused the deal, Elliot Management Corporation aggressively pursued its legal rights for full repayment.

United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default.

While almost no one has sympathy for the rogue Argentine government, U.S. courts have been criticized for undermining global financial stability. Elliott vs Argentina may have severely narrowed the options for reducing the debt obligations of distressed sovereigns. Official international institutions will need to provide greater financial support, stretching their resources.   

Criticism of U.S. courts is not warranted. They were only interpreting and enforcing a contract, not trying to promote international public policy. Sovereign debt contracts have an inherent contradiction. The contract creates a firm commitment to timely repayments but renegotiation requires that the contract not be so firm after all.

For this reason, sovereign debt restructuring has had inevitable legal and financial uncertainties, making the process messy and fractious. Policy makers have therefore been inclined to delay the default decision, as recently was the case in Greece. The delays have increased the eventual cost of the default and created huge inequity in the eventual arbitrary imposition of losses.

But all proposals for resolving the built-in conundrum of sovereign debt continue to fiddle on the margins. The latest by the International Capital Market Association (ICMA) involves writing a complex set of covenants, which will remain subject to interpretation and challenge.

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation.

The economic basis for this radical change is compelling. As many—among them Nobel Laureate, Christopher Sims—have pointed out, the phrase “sovereign debt” is a misnomer. The value of equity held in a private company falls when economic conditions deteriorate. Sovereigns need similar, contractually-transparent leeway to deal with the inevitable adversities. In such eventualities, forgiving some part of the debt makes sense even from the creditor’s perspective because that makes it more likely that the rest of the debt will be repaid. That is why bondholders eventually do renegotiate. But, because they can gain by holding out for full repayment, especially when others are likely to do so, the process is chaotic.

Here is how a more flexible sovereign debt contract may work. The debtor would have the option to defer repayment when, say, the 100-day average risk premium on its debt (the excess interest rate above US treasuries or German bunds) rises above a pre-agreed threshold. Thus repayment obligations would be automatically and predictably eased to handle contingencies, avoiding the angst associated with renegotiating the contract. Such contingent sovereign contracts (“cocos”) would be similar to those in increasing use by banks.

The built-in risk of payment standstill in the cocos would require that the sovereign debtors pay higher risk premia, which would be a prime benefit, not a flaw. The pressure would be to reduce public debt ratios and practice greater fiscal discipline. The present system generates unreasonably low premia on the sacrosanct “sovereign debt” because of the implicit but unreasonable reassurance of full repayment in those contracts. The consequence is that governments pay higher premia on their other obligations—or worse, payment obligations proliferate under the illusion of low premia, creating an unsustainable burden. When eventually all payments cannot be made, losses are imposed on such vulnerable groups as pension holders while well-heeled bondholders pay no, or a small, penalty.

The cocos would also eliminate the endemic incentives to delay restructuring. Under the current system delays occur, in part, because the threshold at which debt restructuring should occur is fuzzy. That fuzziness is compounded by prolonged and uncertain negotiations, which elevates the further risk of contagion to other sovereigns. For these reasons, international financial institutions are inclined to legitimize the delays with optimistic forecasts. The theme always is: restructuring is a good idea, but not in the midst of this crisis. The eventual restructuring imposes higher costs on all.

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor. The standstill would need to be triggered well before insolvency is imminent and, hence, the likelihood of a return to normalcy is high. Economists Charles Calomiris and Richard Herring have made a similar observation for cocos issued by banks. Thus, the process would be incremental and automatic instead of arbitrary and spasmodic.

For example if a risk premium threshold of, say, 5 percent had been in place, Ireland, Portugal, and Spain could have initiated standstills and hence required less fiscal austerity, with reduced hardship on the most vulnerable and a more rapid return to growth. Creditors would have waited but would have eventually benefited by lending to more robust debtors. The sovereigns would have paid a penalty via higher risk premia for their new borrowing and, hence, would have been subject to the more reliable market vigilance rather than being guided by the illogical and fractious centralized system based in Brussels. Perhaps, the European Central Bank’s legally and politically fragile Outright Monetary Transactions would have been unnecessary.

With cocos, it would be in the sovereign’s interest to prevent the risk premium from reaching the threshold and, once reached, to restrain from exercising the option. If the threshold is reached often and standstill triggered, the terms of future access to the market will worsen. Official financial agencies called on to help if standstills persist will also have an incentive for credible monitoring rather than indulging in serially optimistic forecasts.   

Today, the elevation of the sovereign bondholder to a privileged creditor reflects a self-serving mystique fostered by financial lobbies and policy elites. As such, undoing the system will meet more than the usual resistance. However, the technical challenges of introducing sovereign cocos are no greater than that of the ICMA proposal. In fact, cocos are much simpler in design. The novelty of cocos will make the pricing initially more difficult, but will lead ultimately to greater public and private benefit.

The eurozone nations will gain much-needed flexibility in their rigid macro management apparatus by fostering a critical mass of cocos. While the existing overhang of eurozone debt cannot be so resolved, the further tendency to over accumulate debt can be curbed and a more mature future relationship with creditors can be established.

No contract is perfect. The current system, however, generates egregious outcomes

No contract is perfect. The current system, however, generates egregious outcomes. And all the so-called reform proposals retain the traditional implicit guarantees of repayment along with the contractual uncertainties and incentives to delay restructuring. In contrast, sovereign cocos would induce more realistic pricing of debt and help reduce public debt ratios. By automatically triggering a standstill, cocos would diminish the likelihood of reaching the point of no return. Paradoxically, the greater flexibility of cocos will create more predictability—and, hence, greater efficiency and equity.

Republished from Bloombergview with permission

Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to [email protected].

Read about event More on this topic

Past Event

Past Event

The role of the ECB in stabilizing sovereign debt markets

What are the main lessons of ECB interventions in specific sovereign debt markets?

Topic: Macroeconomic policy Date: April 1, 2021
Read article More on this topic More by this author

Blog Post

Thinking big: debt management considerations for the EU’s pandemic borrowing plan

If not handled correctly, the European Union’s transition to take on a new role as an issuer of public debt risks crowding out existing markets. Managing that transition correctly is almost as big a challenge as spending the money itself.

By: Rebecca Christie Topic: Macroeconomic policy Date: December 9, 2020
Read article Download PDF

Policy Contribution

European Parliament

From climate change to cyber attacks: Incipient financial-stability risks for the euro area

The European Central Bank’s November 2019 Financial Stability Review highlighted the risks to growth in an environment of global uncertainty. On the whole, the ECB report is comprehensive and covers the main risks to euro-area financial stability, we highlight issues that deserve more attention.

By: Zsolt Darvas, Marta Domínguez-Jiménez and Guntram B. Wolff Topic: Banking and capital markets, European Parliament, Macroeconomic policy, Testimonies Date: February 6, 2020
Read article

Blog Post

Incorporating political risks into debt sustainability analysis

DSA applies to crisis countries only, but an early warning system identifying vulnerabilities is relevant for all countries. A more general, less stringent, debt vulnerabilities analysis (DVA) could be used to assess countries’ debt management policies and identify vulnerabilities, without leading immediately to policy consequences. A more general framework could also incorporate political risks that are significant determinants of debt dynamics

By: Andrea Consiglio and Stavros Zenios Topic: Global economy and trade, Macroeconomic policy Date: January 22, 2020
Read article Download PDF More on this topic

Policy Contribution

The European Union-Mercosur Free Trade Agreement: Prospects and risks

After nearly 20 years of on-off negotiations, the European Union and Mercosur – a customs union covering Argentina, Brazil, Paraguay and Uruguay – in June 2019 reached a political agreement on a trade deal. But to derive the full benefits from the EU-Mercosur agreement, major reforms will be needed.

By: Michael Baltensperger and Uri Dadush Topic: Global economy and trade Date: September 24, 2019
Read article More on this topic More by this author

Blog Post

Argentina, plus ça change…

Recent primary elections in Argentina saw the defeat by a wide margin of President Macri. This fueled market volatility given expectations of a reversal of reforms after national elections in October; the recent re-introduction of capital controls attests to the extent of the economic fallout. With Macri’s end in sight, this post will review the evolution of the Argentinian economy during his term.

By: Marta Domínguez-Jiménez Topic: Global economy and trade Date: September 9, 2019
Read article More on this topic

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo and Bruegel Topic: Global economy and trade Date: June 11, 2019
Read article More on this topic More by this author

External Publication

Can emerging markets be a source of global troubles again?

According to popular perception, emerging-market economies have not experienced serious macroeconomic and financial turbulence since the beginning of this century. This perception was not entirely correct because it disregarded spill-over effects of the global financial crises of 2008–2009, the consequences of the decline of oil and other commodity prices in 2014–2016, economic and financial troubles caused by violent conflicts and regional political instability.

By: Marek Dabrowski Topic: Global economy and trade Date: May 9, 2019
Read article More on this topic

Blog Post

Whose (fiscal) debt is it anyway?

The authors map how much fiscal debt is in the hands of domestic and foreign holders in the euro area. While the market for debt was much more international prior to the crisis, this trend has since been reversed. At the same time, central banks have become important holders of fiscal debt.

By: Maria Demertzis, David Pichler and Bruegel Topic: Macroeconomic policy Date: February 6, 2019
Read article More on this topic More by this author

Blog Post

Is this time different? Reflections on recent emerging-market turbulence

Since the beginning of 2018, currencies of two large emerging-market economies – Argentina and Turkey – suffered from substantial depreciation. Other currencies also recorded losses. Which factors are determining macroeconomic and financial stability in emerging-market economies? And what can be done to prevent a crisis and avoid its economic, social and political costs?

By: Marek Dabrowski Topic: Global economy and trade Date: November 14, 2018
Read article More on this topic

Blog Post

The consequences of Italy’s increasing dependence on domestic debt-holders

Bruegel’s updated data set of sovereign bond holdings illustrates how a rising share of Italian debt is held by domestic investors – a development with particularly significant implications, in the context of the Italian government’s disagreement with the European Commission over spending plans outlined in its draft budget.

By: Jan Mazza and Bruegel Topic: Macroeconomic policy Date: November 6, 2018
Read article More on this topic

Blog Post

The higher yield on Italian government securities could soon be a burden for the real economy

The increase in the spread between Italian (BTP) and German (Bund) government securities is directly an additional burden for Italy public finance, and thus for tax payers. But it could soon also become a burden for the real economy, as the increased yield on Italian government securities could pull up the cost of bank loans for Italian firms, thus imparting a deflationary impact onto the economy.

By: Francesco Papadia, Inês Goncalves Raposo and Bruegel Topic: Macroeconomic policy Date: September 10, 2018
Load more posts