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Argentina and Ecuador successfully renegotiated their bonded external debt close to the expiration deadline of their respective offers. In many senses, these stories are very much intertwined. In both cases, a parallel can be drawn between the causes and consequences of this serial defaulter pattern, and now also with the proposed remedies.
Haunted by chronic high inflation, Ecuador sought inspiration in the successful Argentine convertibility regime at the turn of the 1990s. However, Ecuador went a step further by relying on the state-of-the-art policy recommendation of full dollarisation that was officially announced on 9 January 2000. Only two years later, Argentina defaulted on its debt for the fourth time since it had gained independence from Spain, also abandoning the peg to the US dollar that had prevailed for one decade. With the demise of convertibility, Argentina eventually resumed printing money to finance a relentless fiscal deficit.
In tandem with accelerating inflation in Argentina, Ecuador slipped into deflation. It’s noteworthy that in the final stages of convertibility, inflation had also turned negative in Argentina. Neither convertibility or full dollarisation got to the root of the problem: fiscal mismanagement. There is no doubt that populism and fiscal profligacy are the ultimate factors behind macroeconomic instability and debt woes in both countries. A rigid monetary framework can only bring temporary relief. Credible fiscal institutions defining spending rules and debt limits are necessary to turn the page for good and leave behind the serial defaulter past.
In the economic assumptions accompanying its debt offer, Ecuador is pledging to grow well above trend while keeping primary spending more or less constant in real terms. In turn, while presenting a more conservative growth scenario, Argentina does not see room for a fiscal adjustment. These promises, even if they look modest like in the Argentine case, could be unattainable under the continuity of the current policy framework. Attempts to introduce structural reforms in Ecuador, such as comprehensive labour reform, have failed. In addition, the outlook for reforms does not look promising. Furthermore, Ecuador cannot resort to a devaluation to overhaul its competitive edge and jumpstart growth.
“A lot more needs to be done such as embracing the path of reform and creating credible fiscal institutions…”
As shown in the graph, economic stagnation and growth volatility have been Argentina’s trademark for decades. Public spending has expanded by 20 percentage points of GDP in two decades, and there is no guarantee that it will not continue rising. As a result, investors will continue demanding a very high risk premium. Most analysts used an exit yield of between 10% and 11% to value Argentina and Ecuador’s swap offers. The important point is that unless there is a positive shock on growth or a major cut in public spending this sizeable interest burden will once again place debt dynamics on an unsustainable path.
Back in April, Argentina introduced a novelty in its first debt offer. Under the Redesignation Amendment, Argentina asked for bondholder consent to unilaterally modify the series of bonds participating in the swap. This “redesignation” could take place even after votes were cast and counted. The rationale is to leave out of the exchange the bonds where collective action clauses (CACs) cannot be activated because of a low acceptance rate. However, these bonds could be engulfed in a subsequent offer leveraging on the fact that CACs were previously activated in the bonds that were left in the redesignated pool (the so-called “Pac-man” strategy).
A much softer version of the redesignation clause was introduced in Ecuador’s July restructuring offer. For Ecuador to be able to redesignate, a minimum participation condition needed to be met of 80% of bondholders accepting the swap. This is geared at protecting investors who do not agree with the terms of the exchange from “Pac-man”. Argentina was able to secure a deal with creditors not only by conceding on better economic conditions in the last offer, but also by qualifying redesignation. In addition, 2005-10 exchange bondholders preserved their enhanced legal protection compared to the 2016 indenture bonds. Protection counts and the attempt by Argentina and Ecuador to rely on legal subterfuges as an aggressive negotiation strategy had limited effectiveness.
Even if Argentina and Ecuador once again successfully restructured their debt, this does not mean that they will leave behind their past as serial defaulters. A lot more needs to be done such as embracing the path of reform and creating credible fiscal institutions. Without these, promises of faster growth will be sterile and debt sustainability issues are likely to resurface. IMF surveillance has shown to be an insufficient guarantee of the soundness of policies. Investors should start thinking about demanding higher standards to buy bonds issued by serial defaulters.