Failure of negotiations with holdout investors puts Argentina into selective default exacerbating risk to currency and contracts

Despite last-minute frantic negotiations yesterday (30 July) in New York between an Argentine government delegation led by Minister of the Economy Alex Kicillof and the so-called 'hold-out funds', no compromise has been reached. As a result, Argentina has defaulted on debt payments on its Discount 2033 Notes. Therefore, Argentina is in default for a second time in 13 years and the eight time in the country's history. Standard & Poor's has already placed Argentina's credit rating on "selective default".

Argentina's USD539-million payment to exchanged bondholders had been due on 30 June. Argentina was willing to pay the interest due and transferred funds to its Trustee for this purpose. However, it was prevented from doing so by United States Judge Thomas Griesa's ruling, which stated that this payment could only be released to note-holders if at the same time Argentina paid USD1.3 billion to its holdout creditors.

The latter had refused to accept prior debt restructurings following the 2001 debt default. Instead, they have demanded full payment on pre-2001 obligations that they own. In refusing to settle directly with hold-out funds, Argentina stuck to the view that if it paid the holdout creditors, this carried the risk that those bondholders who had agreed to restructure defaulted debt in 2005 and 2010 with a 70% haircut would demand similar treatment. Meeting all pre-2001 liabilities in full would require a multiple of Argentina's current reserves of about USD29 billion and is clearly unrealistic.

Argentina now in default

A decision of the US Supreme Court on 16 June not to hear Argentina's appeal was a major setback for Argentina. The decision meant that the prior ruling of Judge Griesa in favour of holdout funds was final. After that the only possibility to avoid default was for the holdouts to request the judge restore a prior "stay order" on the ruling, delaying its implementation. However, this did not materialise and as a result Argentina is in default as of today (31 July).

A proposal by Argentina's banking association (Asociación de Bancos Privados de Capital Argentino: ADEBA) that it was willing to deposit USD250 million as a guarantee bond towards a future final agreement in January 2015 did not succeed either. Such a move would have avoided triggering the Rights Upon Future Offers (RUFO) clause, which expires in January 2015. This clause, embedded in the 2005 and 2010 restructured bonds, states that Argentina will not offer a better deal to other claimants without also extending such arrangements to exchanged bondholders.

Domestic implications

The current default is far from being as catastrophic as that of 2001, it will, nonetheless, have significant negative implications for the country.

In particular, it will further isolate Argentina by sharply constraining its access to fresh sources of funding. The default is a major setback for the country's heavily indebted provinces, which were counting on a positive outcome in New York to be able to issue dollar-denominated bonds to fund their current expenditure. The default will make borrowing for the provinces in the foreign capital markets prohibitively high. In late May, the province of Buenos Aires tried to place a USD500-million bond in international markets, but withdrew the deal after investors demanded coupons in excess of 11%. After the sovereign default, access would be considerably harder and more expensive, if even feasible (which is relatively unlikely).

Additionally, the default is certain to lead to further declines in the country's foreign reserves putting renewed pressure on the peso. This is likely to accelerate and make a second devaluation even more likely, which IHS had already forecast for later this year. In January, the gap between the parallel exchange rate and the official exchange rate rose to 40%, forcing the authorities to devaluate the peso by 23%. A second devaluation would likely further fuel inflation, which is already very high; IHS expects Argentina's inflation to exceed 40% by the end of 2014.

The growing uncertainty and limited access to dollar funding also will impact negatively on domestic and foreign investment, deepening the recession. The economy is already contracting. Most companies are putting planned investment on hold. Moreover, the longer the country takes to reach an agreement with the holdouts, the more serious the economic situation will become in Argentina. Without access to external resources the government will intensify the monetisation of fiscal deficits. In addition, the default will make it more difficult for exporters to obtain pre-financing abroad, which will have a negative impact in the next planting season.

Preserving foreign reserves, currently at about USD29 billion, would be critical to fund current expenditure and service other debt not in default. As a result, the government is expected to tighten the multiple exchange controls in place since late 2011 to tackle capital flight. This is likely to see fresh constraints for private companies in profits repatriation as well as payment of dividends to investors residing abroad. It will also result in new import controls. These will increase operating difficulties for the private sector resulting in further economic contraction.

What next for Argentina's debt?

• Price shock: Argentina's bonds rallied sharply on 29 July, in some cases by 10% on expectations a settlement. Argentina's average bond spread (above US Treasury bond yields) fell dramatically, from 7.07% on 28 July to 5.46% on 30 July, ahead of the adverse announcement dashing hopes of agreement. A sharp corrective fall in prices is now almost inevitable.
• Ratings: Standard & Poor's immediately moved Argentina to a selective default rating yesterday, given the unresolved non-payment on its Discount 2033 Notes series. It plans to maintain this rating while the interest due in June on these Notes remains unpaid. Other agencies are likely to follow. The Selective Default rating is technical, and could be quickly reversed if payments are unblocked. At a later stage, Argentina could be moved to General Default, if other outstanding debt is accelerated and becomes repayable in full, which Argentina is highly unlikely to satisfy.
• Credit default swaps: Prompt application is likely to be made to the International Swaps and Derivatives Association (ISDA) to declare Argentina's credit default swap insurance (CDS) to have been triggered. Unless a prompt solution is found, CDS payout is likely, but not certain. Argentina has USD20.7 billion of such policies outstanding, according to Depository Trust & Clearing Corp.
• Acceleration: 25% of the holders of the unpaid Discount 2033 Notes can seek their acceleration, making their full principal amount due, if the technical default triggered on 30 July is unresolved for 60 days.
• Cross-default: Acceleration of the Discount Notes would risk triggering the cross default clauses on other outstanding Argentine bonds, even if these are not themselves in arrears. In turn, this could make all outstanding debt due for full repayment, forcing the country into a full-scale debt restructuring.

Outlook and implications

Argentina will now embark on a damage limitation exercise. It appears confident that it can weather the storm until January 2015 when the RUFO clause expires. It is worth noting that this time Argentina still has the capability to meet its obligations with creditors, and is not as dependent on foreign capital markets as 13 years ago.

Despite the clearly adverse nature of the technical default, damage could be limited by several factors:

1. Talks involving private-sector temporary purchase of debt owned by the holdout funds are likely to continue, according to local media. If a deal were reached, delayed payments could be unblocked with the consent of the New York District Court, so resolving the current technical default.
2. The RUFO clause in exchanged debt, which Argentina feared would expose it to massive claims from exchanged bondholders if it pays holdout funds in full directly, expires at the end of 2014. Argentina appears reluctant to make any commitment at present given this clause. Once it expires, this obstacle naturally falls away.
3. Given the potential resolution of the current stand-off, either by private sector channels or by direct means in early 2015, it is far from certain that affected Noteholders would see upside benefit from triggering acceleration, rather than awaiting a resolution.

However, the event is highly damaging for Argentina. IHS foresees a deeper recessionary environment with higher inflation, potential for rapid currency depreciation, and increased unemployment. The latter is likely to produce heightened social unrest particularly including nationwide industrial action. Unions are certain to demand wage increases that reflect higher inflation levels. With the fiscal deficit widening and the economy in recession neither the government nor the private sector would be able to meet such demands.

By contrast, unlike in 2001, there are no real signs of contagion in the region. In recent months, both Ecuador and Jamaica have tapped international bond markets successfully, despite their own recent default history. Several recent rating moves in the region (involving Peru and Colombia) have been upward, rather than negative. Unlike in 2001, there is no reason for Brazil to be badly affected other than suffering marginal potential loss of exports to Argentina. It is important to separate between the current technical default, driven by legal problems rather than an inability to pay, from the far deeper and more damaging events in 2001.