Supreme Court’s Argentina Debt Ruling Will Reverberate in Emerging Markets
By Daniel McDowell, June 23, 2014
As the top judicial body in the American justice system, the U.S. Supreme Court is no stranger to setting legal precedents that reverberate for generations. However, more often than not, those rulings have little impact outside of U.S. borders. Last Monday, however, the high court reached a decision that might very well change the face of international finance for years to come. By ruling that Argentina must repay $1.3 billion to a group of persistent creditors, the nine justices potentially delivered a blow to emerging market economies dependent on international debt markets and put America’s global financial power on display yet again.
This story is more than a decade in the making. In December 2001, Argentina—then in the midst of an economic collapse—halted payments on $81 billion in public debt. In an effort to reduce its debt burden, the Argentine government issued an ultimatum to bondholders: Hand over your existing bonds in exchange for new ones worth about 35 cents on the dollar or walk away with nothing. The vast majority of creditors accepted the “haircut.”
However, some creditors opted to sell the old bonds on the secondary market, where a handful of so-called vulture funds scooped them up at a deep discount. Where most creditors saw enormous risk, these hedge funds saw an opportunity for profit. They also had a plan and a bunch of lawyers. Determined to recoup 100 percent of the old bonds’ value, a group of these “vultures” took Argentina to court. These efforts culminated in last week’s decision, in which the Supreme Court upheld a lower court ruling siding with the hedge funds over Buenos Aires and ordered the government to pay up in full.
The ruling’s legal weight is the result of two important facts about Argentina’s bonds. First, because of the country’s less-than-stellar reputation as a borrower, the government issued its debt in New York. This meant that the debt contracts were under New York’s legal purview, which ultimately led to the U.S. Supreme Court.
Second, and more importantly, Argentina’s bonds were issued without what is known as a collective action clause (CAC), which makes any restructuring deal agreed to by a supermajority of creditors—generally 75 percent—legally binding on all remaining holdouts. Because Argentina’s bonds were CAC-free, however, the vultures successfully argued that Buenos Aires could not simultaneously make payments on the new bonds without also paying 100 percent of what they owed on the old bonds, which would be a breach of an equal-treatment pledge Argentina attached to the initial bonds.
The ruling puts Argentine President Cristina Fernandez de Kirchner in a very difficult position. Should Argentina repay the $1.3 billion the U.S. high court has ordered, it would open itself to repaying all of the holdout creditors who did not accept the initial restructuring agreement. That would amount to roughly $15 billion, which Kirchner has already declared her country cannot afford. Yet she may not have a choice. In order to continue making payments on the new debts, but not the old, Kirchner will have to convince the U.S. financial institution in charge of processing its payments—the Bank of New York Mellon—to go along with the plan. That is unlikely to happen, as it would probably land the bank in its own legal hot water.
In short, refusing to pay the vultures would mean Argentina will stop paying all its creditors and, yet again, the country will default on its external debts. The country has already found itself largely locked out of international debt markets since the 2002 default; another episode could cripple the country’s access to foreign credit for yet another decade. The most likely scenario is that Kirchner asks the vultures to meet her at the negotiating table where they will work out some way for the country to make the creditors whole.
Regardless of the outcome in Buenos Aires, the most important consequences of this decision reverberate far beyond Argentina. The hedge funds that held out and refused to accept the substantial haircut they were offered by Buenos Aires have shown that persistence and a good legal team can pay off.
That could now empower creditors to play hardball in future sovereign debt negotiations, as they will have little reason to accept a debt restructuring deal when a few lawyers and a lengthy court case might allow them to recoup all they are owed. Meanwhile, sovereign borrowers, especially emerging market economies that lack credibility in international debt markets, might find investors turning up their noses at bond issuances with CACs. In order to attract buyers, sovereigns might feel compelled to give up the kind of protections that Argentina now wishes it had. Yet, even with a CAC in place, this ruling could reduce the leverage of sovereigns in future debt renegotiations, as it takes just one out of four creditors holding out to prevent the CAC mechanism from being activated.
Indeed, this is precisely why the International Monetary Fund (IMF)—the international institution that typically mediates between sovereigns and creditors in such negotiations—seriously considered filing a brief on behalf of Argentina with the U.S. high court. Sovereign debt renegotiation is already a complicated, difficult and messy process, and the fund is very concerned this is going to make its job more difficult. Ultimately, the IMF decided against siding with Buenos Aires reportedly because the U.S.—the most powerful country within the institution—opposed the position.
In the eyes of creditors, the Supreme Court has helped to impose some order in international debt markets that lack effective governance and empower deadbeat governments to back out of legal commitments without so much as a slap on the wrist. In the eyes of many governments, the outcome provides step-by-step instructions for other deep-pocketed hedge funds on how to bleed cash-strapped countries and their citizens dry. Despite these differences, there is one conclusion that both sides can agree on: When it comes to governing international financial markets, the U.S. is in a class all its own.
Daniel McDowell is an assistant professor of political science in the Maxwell School at Syracuse University specializing in international political economy. He is a regular contributor to World Politics Review.