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Government debt restructuring raises
spectre of default.
On 1 November, the markets watched with keen interest as the De la Rúa
administration announced another series of economic measures designed to
balance the books and kick-start the ailing economy. The measures
included a plan to restructure public debt. The government promised to
swap some US$ 95 billion in outstanding bonds for new tax revenue bonds
with an extended maturity of three years bearing a fixed rate of 7% or a
variable rate at LIBOR plus 300 basis points. The first stage of the
bond swap is estimated at US$ 60 billion and is likely to be offered to
local holders, which include banks, mutual funds, pension funds and
insurance companies who are perceived as more acquiescent to government
demands. The next phase will be implemented in two to four months and
will involve foreign holders. The rationale behind the delay in
starting the second phase is that the government hopes to secure
additional bilateral and multilateral guarantees in order to convince
international holders to accept the lower interest payments. The
government expects the debt swap to generate some US$ 4 billion in
savings through the end of next year. It hopes to use the freed up
funds together with new tax measures to provide the ailing economy with
a much needed boost. At the same time, the funds should preclude the
need for further salary cuts to meet the “zero deficit” restriction.
While labelled as “voluntary” the restructuring
technically constitutes a default since it reduces the net present value
of holders’ bonds and both Fitch and Standard and Poor’s have acted
accordingly, cutting their sovereign debt ratings from CC to C and from
CC to SD (‘Selective Default) respectively. The market had already
anticipated the possibility of a worsening Argentine debt situation.
This was reflected in a widening of the EMBI spread on Argentine
sovereign debt by 495 basis points in October to 2,134 by the end of the
month over comparable US treasuries. The spread widened further
following the government’s swap announcements to 2,331, the highest in
the world, and places Argentine debt quality below Nigeria and Ecuador.
The government, nevertheless, is confident that bondholders will engage
in the swap, since lower payment is likely to be preferred over outright
non-payment.
Devaluation or dollarization ever
present.
In order to convince investors to accept the lower interest payments,
the government would have to provide substantial guarantees, such as tax
and accounting benefits. However, on 9 November the majority of
provincial governors refused to agree to lower their share in tax
transfers from the federal government. In addition, the government also
may have to commit to not altering the current exchange rate regime.
Investors are increasingly concerned about the viability of the dollar
peg since pressures on the currency are mounting due to accelerating
capital flight. International reserve outflows quickened further in
October, dropping by an additional US$ 2.8 billion, more than half of
the resources received by the International Monetary Fund (IMF) in
September. The reserve outflow has been accompanied by a corresponding
fall in bank deposits. These fell by US$ 2.9 billion in October to US$
75.1 billion. Consequently, interest rates have soared - those offered
on 30-59 day deposits rose from 17.02% in September to 33.85% at the end
of October.
The 1991 Convertibility Law requires the government
to maintain reserves sufficient to cover the monetary base (notes and
coins in circulation). So far, the Central Bank has been able to
cushion the reserve outflow observed since the end of July with some US$
12.6 billion of excess international reserves that have accumulated
since 1996 above the minimum level required by the Convertibility Law.
However, by the end of October, this cushion had shrunk to US$ 6.4
billion. If the current outflows persist unabated, the government will
have either to request expedited reimbursements from the IMF or tap into
an existing contingent credit line of US$ 3.0 billion with commercial
banks.
The government is unlikely to wait for international
reserves to reach critical levels before reacting and, failing to stem
the capital flight, may consider dollarization as a last resort.
However, dollarization is also likely to prompt further deflation of the
economy, as Argentine relative prices will have to adjust to the current
imbalances with major trading partners. However, all government
authorities have not tired to deny any such plans. Moreover, neither
the United States nor the IMF are likely to encourage the Argentine
government to resort to this drastic measure. While the additional
fiscal infusion resulting from a successful debt restructuring may
provide some impulse to the economy, dollarization would prompt further
deflation of the economy, as Argentine relative prices will have to
adjust to the current imbalances with major trading partners. Further
deflation resulting from dollarization would provide strong downside
pressure at a time when the economy needs a healthy rebound. Consensus
Forecast figures this month show that participants believe the
government will stand by the currency peg as evidenced by longer term
forecasts, which continue to see the currency at par with the US$.
Delay in the debt restructuring, additional political
hurdles or wavering support from multilateral organizations could
precipitate further the reserve drain and, if the outflow persists at
the current pace, could quickly exhaust reserves and threaten
convertibility. Under this scenario, the government would have not
other alternative but to devalue. Devaluation would have disastrous
consequences on the economy, as consumption and investment are likely to
plummet even further. In addition, since virtually all of the debt in
Argentina is dollar denominated, widespread default would put severe
strains on the financial system. Finally, with most of public debt
obligations denominated in foreign currencies, the likelihood of a
default would increase substantially. The credibility lost as a result
of an exchange rate regime change and default could lock Argentina out
of international markets for an extended period.
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