To Pay or Not to Pay: Argentina and the International Debt Market

Editor's note. Argentina is in the midst of a continuing saga regarding its 2002 default on its sovereign debt, a case that the US Supreme Court will decide soon. HBS finance professor Laura Alfaro, who served from 2010 to 2012 as Minister of National Planning and Economic Policy in her native Costa Rica, recommends a course of action sure to anger banks and fund managers: absolute sovereign immunity, which is the way things were done before 1976.

Argentina's escalating financial crisis is taking on the look and feel of 2002, when it defaulted on $82 billion worth of sovereign bonds, a move that triggered economic chaos in that nation. Along with Argentina's current struggles—the sharp devaluation of its currency, rampant inflation, and civil unrest—past financial problems remain unresolved and much on the minds of its creditors, a few of whom have not yet been repaid from the default.

Back then, Argentina tried to fend off creditors by adopting a hard-line attitude about reducing its debt obligations. When it initiated a bond exchange offer in 2005 and told its creditors to "take it or leave it," the republic triggered a hornet's nest of reaction that ended up in the federal court in New York City. Argentina categorically refused to negotiate with investors and halted payments to any creditor that rejected its offer. Investors who agreed to the exchange offer received new bonds worth 73 percent less than the value of their initial investment, a harsh haircut compared to consensual sovereign bond restructurings. A few holdout investors refused to concede and sued. These so-called "vulture" investors, hedge funds that bought the defaulted loans at deeply reduced prices and then sued Argentina for the full amount, have been willing to stay in the fight for the long haul. The legal battle will culminate in the United States Supreme Court, with a ruling expected in June.

Not Setting Precedent

While most observers remain focused on the outcome of the Argentina case, the bigger question is what impact the case will have on the sovereign debt market and on future restructurings in general. In the current global environment, where trouble in emerging market economies is setting off worldwide alarms and stock market unease, is Argentina setting precedents that will make it grueling, if not impossible, for emerging nations to restructure their sovereign debt? Judging by other restructurings over the past four decades, Argentina is an anomaly, a case worth watching but unlikely to set any lasting legal or economic precedent. Ongoing litigation is predicated on what the Second Circuit Court of Appeals called Argentina's "uniquely recalcitrant" negotiating strategy.

Until the 1970s, the act of lending to a foreign country was little more than "an act of faith," as economic advisor Herbert Feis said in 1930. Given that sovereign immunity prevented nations from being sued in foreign courts without their consent, the ability to enforce the terms of foreign loans often led to pitched political battles of will with the implicit threat of war as the only recourse for creditors. Between the end of World War II and the 1970's there was little foreign borrowing, making default a relatively uncommon occurrence.

The passage of the Foreign Sovereign Immunities Act (FSIA) in the United States in 1976 changed all that. After the passage of the FSIA, sovereign debtors started to waive their sovereign immunity. Private institutions could now sue foreign governments in US courts in the event of a default, an epic change that many believe helped the sovereign lending market evolve on a grand scale. It also led to a wave of litigation that did little more than disrupt or delay sovereign debt restructurings. Over the next two decades, lawyers, lenders and borrowers realized the actual implications of the law: Obtaining a favorable court judgment was possible with the right covenants; collecting on that debt was not. Finding "attachable assets" that successful litigants could access remains challenging to this day, since sovereign nations have few available commercial assets overseas that can be attached.

One of the most damaging results of the FSIA is a false perception that foreign debt was made less risky than it is. The limited enforcement rights of investors means that sovereign debt remains risky, regardless of whether it is issued under foreign law. In fact, there is no grand scheme that will emerge from the Argentina case that will in some way ameliorate the risk. Given the lack of conversation about changes to the international financial architecture to manage and resolve debt crises more effectively, let me offer a radical proposal to get a discussion started before a new wave of crises emerges.

A Shocking Idea

I recommend returning to the pre-1976 world where there was absolute sovereign immunity, where each country issued sovereign debt under its own legal jurisdiction, and a creditor could not sue Argentina in New York. This may be a shocking idea for the banks and fund managers who trade in foreign debt as well as for emerging market countries. "The cost of funds will go up," naysayers may cry. "We won't get any money; no one will invest in us."

“If you lend to Argentina, you are dealing with Argentina”

But I predict the opposite will happen—an outcome with potentially significant positive results. This change will allow debtors and creditors alike to better understand and acknowledge the risk inherent in sovereign debt lending. If you lend to Argentina, you are dealing with Argentina. Giving the legal power to New York has not made it easier to collect on defaulted debt.

In truth, most countries repay their debts, and sovereign default is far from the norm. At stake in the Argentina case is the idea that one should use foreign institutions and foreign courts to help financially suspect countries improve their lack of policy credibility and the weakness of their domestic institutions. In fact, no such panacea exists. The Argentina scenario is a harsh reminder that attempts to improve the international financial architecture without addressing the underlying weaknesses and distortions of a debtor nation are simply counterproductive.

Rather than stifling investment, the proposed change will hopefully trigger increased focus on equity-type investments, on entrepreneurial activities that actually produce products and services to attract investors, and it will shine a positive light on an emerging economy. With these actions, developing countries may concentrate more on the economic building blocks needed for a stable future.