ARGENTINA: Bond swap opens window of opportunity

Analysis

In December 2001, Argentina declared the world's largest sovereign debt default, and the fifth in the country's history (see ARGENTINA: Pain ahead as Duhalde devalues peso - January 7, 2002).

On March 3, it was announced that 76.07% of holders of defaulted bonds, worth 81.8 billion dollars (102.6 billion including past due interest), had agreed to exchange them for 35.2 billion dollars in new bonds in the swap opened in January 2005. Public debt fell from 191.3 billion dollars to 125.3 billion as a result.

Successful restructuring. The swap's success is mainly explained by the favourable international environment. The fall of long-term international interest rates reduced the write-down in net present value from 76% in June 2004 (when the restructuring proposal was announced) to 66% in February 2005 (see ARGENTINA: Restructuring offer faces uphill battle - June 7, 2004). Most investors were thus encouraged to take part in the restructuring, while those who were more reluctant to participate realised that a high acceptance rate would reduce prospects of a second (and better) opportunity.

The restructuring has increased the share of peso bonds in public debt. Before the restructuring, 66% of the eligible debt was denominated in dollars, while peso bonds accounted for only 10%. Following the swap, 37% of debt is denominated in local currency, while the share of dollar bonds has narrowed, also to 37%. The higher share of peso-denominated liabilities helps to reduce exchange rate risk, isolating the repayment capacity from sudden adjustments in the foreign exchange market due to negative external shocks (such as further US interest rate rises).

Swap structure. Most new bonds offer a fixed interest rate. This, combined with longer maturities -- the average is estimated to have risen from 8.6 to 14.2 years -- has reduced exposure to future financial crises. The proportion of debt issued under Argentine jurisdiction has also increased after the swap, despite the potential risks associated with this: in 2002, domestic investors suffered heavy losses when the government converted to pesos dollar-denominated public debt issued under domestic law. However, the fact that foreign investors have also suffered major losses, and that, thus far, international litigation has proved unsuccessful in recovering those losses, has reduced the attractiveness of debt issued under foreign law.

New peso-denominated bonds will be adjusted by an inflation-linked coefficient (CER). In fact, the expectation of higher inflation (estimated to reach about 5-8% in 2005) encouraged sustained demand for peso bonds during the restructuring. The Central Bank will need to maintain both low inflation (in order to reduce the debt burden) and a competitive exchange rate.

Debt sustainability. Despite the 'pesoisation' of restructured debt and the significant write-down, the debt burden remains very high: it is estimated that, after the restructuring, the public debt-to-GDP ratio has fallen from 120% to 72%. This compares unfavourably with the 54% recorded in 2001, just before the economic collapse, and with the Maastricht Treaty criterion (60%) and the ratios recorded in Chile (31%) and Brazil (52%).

Zoom

During the 1990s, the expansion of domestic output and the strength of the peso (linked at one-to-one parity with the dollar under the Convertibility Plan) were the main factors underlying the improvement of debt indicators. However, Economy Minister Roberto Lavagna has argued that the low debt-to-GDP ratio recorded under convertibility did not reflect Argentina's real repayment capacity, as it did not take exchange rate risk into account. As the government is seeking to avoid a major appreciation of the peso, debt sustainability will depend on slow public debt growth or, in particular, net debt cancellations.

The IMF. In the 1990s, under the Brady plan, debt swaps were usually backed by an economic programme agreed with the IMF, intended to ensure that governments would follow sound economic policies and thus be able to meet debt payments. This has now changed: the agreement that Argentina reached with the IMF in September 2003 was suspended in mid-2004 owing to slow progress on structural reforms and disagreements over the primary surplus target (see ARGENTINA: Stand-by suspension poses debt risk - August 11, 2004). Following the success of the debt swap, the Argentine government is now in a stronger position to resume talks with the IMF for a new accord.

President Nestor Kirchner's aim is that the new agreement should focus on short-term quantitative targets, which have been comfortably met in recent years. However, the IMF is convinced that structural reforms are needed to achieve sustainable growth, and it is expected to insist on the following issues:

• Holdouts. The IMF will ask the government to define a clear strategy to deal with those creditors who did not enter the swap; as 24% of the defaulted debt was not restructured, Argentina could face potential lawsuits for a total of some 20 billion dollars (around 13% of GDP). Although the government continues to deny any possibility that the swap will be reopened, the most likely long-term alternative is some renewal of the offer for those holdout creditors who desist from filing lawsuits against the government.
• Utilities rates. The freeze of utilities rates has contributed to keep inflation under control and maintain competitiveness, so the government's tough stance on this issue is widely supported by public opinion (see ARGENTINA: Little progress on utilities' contracts - December 17, 2004). Pending renegotiations include those with telecommunications operators, and water, electricity and natural gas distributors. Frozen rates have discouraged investments and there is the risk of bottlenecks in energy provision.
• Tax reform. The 2003 agreement included the commitment to eliminate export taxes and the financial transactions tax, but these goals were not met. Longer-term objectives, such as the removal of distorting taxes and existing exemptions, and the simplification of tax rules and structures, will probably be delayed.
• Provincial finances. The long-awaited reform of the revenue-sharing scheme between the nation and the provinces will also be on the agenda, with the aim of reinforcing fiscal responsibility at the provincial level (see ARGENTINA: Fiscal bill highlights policy limitations - June 18, 2004). However, it is unlikely that, in an election year, Congress will approve a controversial reform pending since the mid-1990s.
• Banking reform. The IMF will call for the strengthening of banking supervision and the reform of public banks, apart from the resolution of the outstanding compensation due to banks following the unequal conversion to pesos of assets and liabilities (see ARGENTINA: Stronger banking sector still faces risks - September 10, 2004). Compensation claims totalling 13.5 billion pesos remain pending.

Government response.Unpopular issues such as tariff increases and revenue-sharing are unlikely to be tackled before the October legislative elections. The government may postpone the agreement until the second half of the year and renegotiate public utilities rates without pressure. Since the suspension of the agreement, Argentina has repaid IMF loans totalling 2.6 billion dollars, and the Fund may also be keen to postpone an accord and continue to receive payments. Debt payments due to the Fund this year total 3.8 billion dollars. There are reports that the government would be willing to pay the principal (3.3 billion dollars), in order to achieve a greater degree of economic policy autonomy. In this case, government borrowing requirements would shift from a 1.4 billion dollar surplus to a 1.9 billion dollar deficit. These would be met either in the domestic market (if the roll over of domestic debt issued after the default is greater than expected), or abroad: President Hugo Chavez has recently announced that Venezuela may buy 500 million dollars in Argentine bonds.

Capital controls? The government will seek to prevent massive capital inflows after the restructuring. Short-term capital inflows can be highly destabilising: a speculative attack could lead to a sudden fall in the peso, raising the risk of a financial crisis. On the other hand, the Central Bank aims to avoid a major currency appreciation in order to maintain competitiveness. In recent months, the Bank has increased its intervention in the foreign exchange market to sustain the dollar price, though at the expense of monetary expansion: the monetary base increased by 10% in the fourth quarter of 2004. Considering the recent acceleration of inflation (annual inflation rose to 8.1% in February), this is a risky strategy.

Central Bank authorities are considering different measures to inhibit a surge of capital inflows, such as the removal of foreign exchange controls on exports earnings -- which, in effect, require exporters to sell their foreign revenues to the Central Bank. This measure, adopted during the 2002 crisis, aimed to increase the supply of foreign exchange in the domestic market in a moment when hard currency was badly needed. Since conditions have radically changed, it would be convenient to lift the measure.

Capital account restrictions. However, the government is likely to introduce other capital account restrictions. In line with the Chilean practice, capital controls would take the form of unremunerated reserve requirements applied to capital inflows maturing within a year. Thus, the requirement would act as a tax deterring short-term capital inflows. This would expand on an existing capital account restriction, which requires capital inflows to remain for at least six months.

Those who support the adoption of such restrictions argue that they help to isolate the economy from the cyclical nature of financial inflows, which tend to increase the impact of both periods of economic expansion and recessions. Those who object argue that they raise domestic interest rates, which mostly affect companies (such as small businesses) unable to tap international markets, and that there is no evidence that they are effective because weak controls allow them to be easily eluded. However, in Chile, such restrictions appear to have affected the composition of capital inflows, inducing longer maturity.

Investment increase? Despite eventual restrictions on the capital account, inflows are expected to return after the restructuring. The resolution of a debt crisis usually leads to a rally, and this will not be an exception. Argentina's stock market has recently boomed: the Merval index of leading stocks rose by 19% between January 14 (when the debt swap offer was opened) and the end of February, to reach a historical record of 1,600 points. Credit rating agencies are planning to raise Argentina's debt rating, so bonds can again be acquired by some institutional investors. Capital gains on restructured debt are expected to reach 20% soon after the end of the restructuring: these high yields are expected to promote the demand for peso-denominated financial assets.

The end of the default will encourage banking activity. Banks are highly exposed to sovereign risk, as public bonds, loans and pending compensations account for nearly half of their total assets. The resolution of the debt crisis and the upward trend of public bonds prices will improve banks' balance sheets and restore savers' confidence, badly damaged when dollar-denominated deposits were frozen and converted to devalued pesos in the aftermath of the economic crisis. Corporate finances will also benefit. Following the debt swap, the country risk premium is estimated to have descended from 750 basis points to 500, so the discount rate at which investment projects are evaluated is lower and the return therefore higher.

Capacity investments. Foreign direct investment (FDI) is also expected to rise, as the relaxation of credit constraints and the favourable economic outlook make investment projects more attractive. The companies expected to take advantage of the re-opening of credit markets and the surge of FDI are those in the primary sector (agriculture, oil and mining) and some manufactures (such as steel, chemicals, cars and paper), while public utilities -- the main recipients of credit during the 1990s -- will have to wait until the renegotiation of contracts is concluded.

Investment growth is key to sustaining the current economic expansion. In 2004, gross fixed investment is estimated to have increased by 36%, reaching 18% of GDP. However, this is still below the 21% recorded in 1998. The sharp contraction in GDP after the 2001-02 crisis left considerable spare capacity, but the output gap is expected to close by the end of 2005 and new investment will be needed to face growing demand. Manufacturing output is near full capacity, particularly in sectors such as steel and aluminium (operating at 94% of full capacity), petroleum refining (91%), and paper and cardboard (81%). Investment in the energy sector (especially natural gas and electricity) is also crucial to prevent bottlenecks and sustain economic growth.