Argentina has defaulted on its debts today for the second time in 13 years. A New York court has ordered that Argentina can’t pay its current bondholders unless Argentina pays debts in full that are owned by a hedge fund. Argentina wants the hedge fund’s debts to be paid off at a steep discount. To avoid default Argentina would be required to extend full payment to all creditors who had previously agreed to a 60% haircut which would be a massive increase in the amount of debt that was currently agreed to when the default of 2001 was settled out of court. This is unaffordable. The default is not actually at the will of Argentina but is as a consequence of them being unable to afford to honor the pari passu (“step-by-step”) clause that the New York judge has enforced. This clause requires equal payment to all parties of bond holders instead of a few getting a better deal.
The default was widely anticipated by the markets, however the potential implication is that global investors may be less willing to invest in EM debt thus diverting more capital to Developed countries and contributing to lower interest rates in Developed countries and a lower amount of growth in EM countries, which is disinflationary on a global scale. If EM countries are less willing to go into debt in the future then their growth rates will be lower. The main global drivers of growth are EM countries, whose growth may have been fueled by unwise and excessive use of debt. The coming reduction of new EM debt will actually make EM countries better because they will have to use capital more wisely for projects the best rate of return. This happened in the U.S. during the Volcker era in the 1980s short term rates were as high as 22% and long term rates were 14% so only projects with a high expected rate of return could get approval by management (using long term rates as a benchmark) and thus this made the business community evolve into a tougher, stronger nature leading to higher corporate profits.
The possibility of EM debtors becoming reluctant to borrow from U.S. lenders could result in them seeking loans from China. This would benefit China because they would issue loans in Yuan and the Yuan would be sold off in the open market by the debtors as they spend the proceeds of new loans thus making Yuan go down and increasing China’s exports.
The risk of an Argentine default is that it will trigger payment of CDS insurance which will cost U.S. banks that have sold these policies. Of course banks are required to hedge their bets so hopefully they won’t go broke and will merely suffer a bad quarter. But this can act as a damper on lending if a bank’s net worth is reduced then new loan issuance may have to be frozen until a bank with impaired capital can raise enough net worth to be allowed to expand its loan book.
Perhaps the greatest risk is that the default will scare investors away from all types of foreign and domestic below investment grade bonds and loans, creating a credit crunch and economic slowdown. Today the ETF “JNK” which owns domestic junk bonds, was down 0.39% even though the Federal Reserve’s policy meeting today and the release today of statistics about a huge improvement in GDP implied that the economy is expanding, which implies less risk for junk bonds. The “EMB” ETF for EM bonds was almost flat, down slightly by -0.04% today.
Economists have joked that there are four asset classes of foreign countries: EM, Developed, Japan, and Argentina. The case of Argentina is one where they were spoiled by the commodity boom which made them less careful about wisely using debt. Ironically if they were a resource poor country they would have been motivated to be more careful to develop their economy and avoid excessive debt. This is called the “resources curse” where EM countries with bountiful commodity wealth fail to follow the discipline of the markets and end up squandering their “inheritance”. By contrast, Japan in 1945 had no natural resources and had lost its manufacturing assets. They were forced to grow slowly and carefully and thus avoided wasting resources, resulting in an enormous boom. (Unfortunately they got into way too much debt in 1980-89 and got into massive debt troubles for other reasons caused by the Central Bank trying to stimulate the economy, completely forgetting the lessons of the post-1945 recovery).
The giant banks have learned to diversify their risk so probably nothing bad will happen from Argentina’s default. But junk bond and EM investors shouldn’t let their guard down. Investors need independent financial advice about the risks of EM bonds and junk bonds. I wrote an article “Supreme Court ruling on Argentine bonds: will an EM bond crisis occur?”