Last week, international capital markets enthusiastically granted redemption to Argentina, a serial defaulter on money it has borrowed from external creditors. The scale of this reaction is counter-intuitive and could provide the wrong incentive underpinnings for financial relationships that involve an important element of trust. Yet this kind of forgiveness has occurred regularly -- for good and bad reasons -- and, for the most part, prematurely.
Argentina defaulted in December 2001 and spent almost 15 years in protracted legal conflicts with bond creditors, including a group of particularly hard-nosed “holdouts” that included hedge funds that had purchased the bonds inexpensively on the secondary markets. Despite many court rulings, the two sides could not arrive at an agreement that normalized badly disrupted capital-markets relations.
The situation changed with the arrival of a new team in Argentina led by President Mauricio Macri, who took office in December. Armed with a new court ruling and a preliminary agreement with most of the holdouts -- and without waiting for the full blessing of multilateral institutions such as the International Monetary Fund -- the government tested the waters through a new issue of long-dated bonds. The result was headline-grabbing.
In what can only be described as a food fight among private creditors, about 2,000 orders were placed for the new bonds, resulting in a total notional demand of around $70 billion, a record number for emerging markets. Buoyed by the exuberant market reception, Argentina upsized its offering and made it less attractive for potential buyers by reducing the issuance yield by almost a full percentage point.
The result was a $16.5 billion emerging-markets bond issue and terms that were a lot more favorable to Argentina than the current market pricing for similarly rated debtors. And the markets' immediate reaction to the bonds added to the government's sense of triumph. Their prices went up, further widening the yield gap in favor of a serial defaulter compared with countries that are currently deemed similarly creditworthy, including those that do not have Argentina’s history of repeated broken promises. And for an overall marketplace that has repeatedly been through periods of liquidity strains, including in January and early February, the huge Argentine issue ended up receiving a liquidity bonus rather than the penalty it could attract.
This type of creditor behavior is not without precedent. The history of emerging-market debt contains other cases when creditors rewarded a borrower that had recently experienced an ugly default, sharp confrontations and hadn’t yet worked effectively with multilateral institutions (Russia after its 1998 default and Venezuela more than once). The creditors' relatively easy approval has both good and bad reasons.
Given Marci’s electoral promises and initial policy steps, including the bold liberalization of the foreign-exchange system and the decision to let the currency find its equilibrium level, there are reasons to believe that Argentina’s economic outlook could be different this time. Given that the latest episode of Argentine exclusion from capital markets was a particularly long one, it is easy to see how credit committees could convince themselves that the probability of sustained improvement in the country's creditworthiness and payment behavior is notably higher. And maybe this government could work better with the IMF in formulating and implementing a medium-term reform program.
There are also bad reasons. With the prevailing low and, in some cases, negative yields on government bonds, some investors were dazzled by the yields of 7.5 percent to 8 percent on the new Argentine 10- and 30-year bonds. Indeed, the Argentine book isn't heavily dominated by dedicated emerging-markets investors, but reportedly included significant “cross-over” interest, including investors who seldom venture into these markets. That includes buyers guided by short-term return expectations. They believe that Macri's Argentina has a stretch of safe economic and financial runway ahead of it, and they are comfortable that market liquidity will be available when they judge it is time to exit.
Others are taking an approach that is even more short term, given the extent to which this bond issue was hyped by the investment bankers. Their expectation of profits comes from the “flip” -- that is, selling the security for a gain shortly after they have been allocated their share in this highly over-subscribed event.
There are three conclusions to draw: