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March 10, 2005

Martin Wolf on Argentina's Successful Refinancing

He writes:

FT.com / Comment & analysis / Columnists - Martin Wolf: Argentina holds a weak hand: What are the lessons of Argentina's successful debt restructuring? For a success, in its own terms, it unquestionably is: Argentina has gained 76 per cent acceptance of a deal to reduce $100bn in debt by about 70 per cent in net present value. Everybody needs to learn the lessons. But Argentina also needs to exploit its opportunity. Alas, it seems more likely to deserve its reputation for never losing an opportunity to lose an opportunity.

The first lesson is that if a sovereign has decided that it makes more sense to default than to service its debts, only a more powerful sovereign can change its mind.... The second lesson.... Lending to sovereigns can indeed be risky, particularly to those with a deserved reputation for imprudence.... The third lesson is that worries over the moral hazard caused by rescue packages have been hugely exaggerated. Both creditors and debtors now realise that official assistance will not rescue them from the consequences of an insolvency. Creditors have experienced huge losses. Argentina has discovered that the International Monetary Fund lent it the rope with which to hang itself. The external help did not insure Argentina's politicians but made the results of their mistakes more painful.

The fourth lesson is that, however costly a default may be, not defaulting is occasionally costlier still. The costs to the defaulter are obvious: a painful crisis, a lost reputation, higher interest rates and financial disarray. This is not a route to be followed lightly, as Brazil under president Luiz Inacio Lula da Silva rightly concluded. But once creditors realise that the costs of not defaulting are, in the eyes of the indebted country at least, greater than those of defaulting, a vicious circle ensues: interest rates soar, credit dries up, the economy weakens, credibility further deteriorates and interest rates go up still further. In 2001, Argentina's economy was contracting while interest rates on its foreign loans were vastly above those on US treasuries (see chart). In this situation, not defaulting became an incredible and so ultimately infeasible option.

The fifth lesson is that once default becomes the least bad option, the optimal default is likely to be deep.... The sixth lesson is that the international community in general and the IMF in particular need to rethink their approach to life after a default....

Where, finally, might Argentina go now? The country is, alas, capable of throwing away any opportunity. Yet that is all default offers.... From the asymmetric conversion of bank liabilities and assets into pesos, which did such damage to the financial system, to the refusal to permit adequate adjustment of utility prices, which is undermining needed investment, short-sighted populism holds sway. By crowing over the scale of the default rather than regretting its necessity, Néstor Kirchner, the president, can only have frightened creditors and foreign investors further. Argentina is demonstrating once again why it has been both a serial defaulter and long-running economic failure. That may be the least important of the lessons. It is among the most depressing, all the same.

But countries should be able to default and restructure their foreign debt without having real GDP per capita fall by a quarter and without destroying their domestic financial system. Argentina's default was extraordinarily costly, for reasons that seem to me to boil down to large-scale political incompetence.

Posted by DeLong at March 10, 2005 11:21 AM