Sunday, 25 November 2012

Oh ! What a mess

Come on Argentina. How often do you ask everybody to cry for you ?  On Wednesday, a US District Court Judge detonated an atom bomb (metaphorically, thankfully), in the world of financial markets. As usual, Argentina was at the centre of it. Here is the story, with a little bit of history.

In 2001, Argentina defaulted on its sovereign debt - one of the rare instances of a major country doing so. A default essentially means that a country has no money on the due date to repay a loan it had taken and tells the creditors to fly a kite. The consequences of such an action are drastic - the country immediately becomes an international pariah in financial markets and nobody would lend to it anymore. That has been Argentina's lot for the last decade, and the situation Greece is desperately trying to avoid today.

When Argentina defaulted, most of its creditors got together and negotiated a "restructuring package" which meant that they would get something back at least - spread over a long period of time. It was a crappy deal for the creditors, but at least they would get something. They did this settlement twice- once in 2005 and again in 2010.

Two hedge funds Elliott Associates and Aurelius Capital, however chose not to negotiate and filed a case in the US courts asking for payment in full. The court gave its sentence last Wednesday, which is the metaphorical atom bomb I referred to. The judge ruled that Argentina will have to pay in full to these two hedge funds who sued, even in priority to the vast majority of creditors who settled ! The amount is some $1.3 bn.

This action is like poking a stick in a hornet's nest. All sorts of ramifications abound. First is the predictable response from Argentina, telling the US judge to go stuff himself, saying he cannot order a sovereign nation to do anything. But since the original debt was issued in the US and in dollars, there is some jurisdiction for US courts. However, short of sending in the army, how would the US enforce this decision ? It is hardly likely to start a war to satisfy two hedge funds.  It can resort to freezing Argentinian assets and the like, creating a messy situation.

The creditors who negotiated and settled are crying foul. They will have to wait for some 30 years and get a percentage of the amount, whereas these two funds are supposed to get their money in full immediately. They are suing to stay the decision giving these two funds priority. So anybody who negotiates in future is an idiot. Greece, which is trying to negotiate a restructuring package currently is quivering in the boots.

Then there is the question of a nation "starving" to raise money to pay "evil hedge funds". An angle that is sure to stoke the fires against wicked capitalists. Cristina Fernandez, the Argentinian President, who can effectively rabble rouse, is already singing this tune.

Argentina is appealing (interestingly while saying that the US courts should f@&* off at the same time !) . This will go all the way to the US Supreme Court. 

All this raises the issue of countries borrowing too much and not being in a position to pay the debt back. Very often the money borrowed is wasted away - in subsidies, doles, etc etc. Every country is guilty of this; just witness what the US is up to with debt at completely unsustainable levels - where are they spending the money they are borrowing ? - in fighting wars in Iraq and Afghanistan, in providing free health care to the elderly and the poor and doling out money to the unemployed. How will any of this yield a return so that the debt can be paid back ? Every country is simply borrowing more to pay back the original debt and keep doing exactly what it has been doing.

 Oh ! What a mess.


sriram khe said...

I wonder whether, in your global wanderings, you have come across way too many Argentine beauties who have crushed your heart and you are taking it out on them by dissing their country .... hehe :)

Anyway, on a serious note, it is crazy that modern life--whether it is countries or businesses or households--is so much tangled in debt. In my own life, I am over-leveraged, under the assumption that my revenue stream will continue at this level, if not higher, and that I can pay off my debts.

I once told the chancellor of our university system that we need to make sure that our students have financial literacy--leading a successful middle-class life, in the US at least, requires an understanding of incomes and expenditures and how to juggle debt.

As countries, too, there is quite a bit of successful debt-juggling that is required. Argentina is a classic case of fumbling it over and over again. It makes countries like India look good, in comparison.

There is one important difference when it comes to the US taking on debt: its currency is also the global currency, for all practical purposes. So, unless some other competitor comes along, the US can inflate its way through these debts, and make it a problem for other countries :) Martin Wolf, of the FT, wrote a couple of years ago, "To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender"

gils said...

ivangalam first ethuku kadan vangaraanga?? oru country kadan vaanguthunna ethuku vaangum?? road poadava? illa govt employees salary kudukava? illa vera pudusu pudusa armoury vaangava? enna basisla ivanga kadanuku vaddi fix panuvaanga?? and returns etha base panni katuvaanga?? and kadan kattalaina yaara pudipaanga??

Reflections said...

I'm thinking of the creditors who settled...they must be kicking themselves settling for so less;-P

And "Every country is simply borrowing more to pay back the original debt and keep doing exactly what it has been doing." a scary line.
I'm even afraid to think where it is all going to end///

Ramesh said...

@Sriram - If only, if only :) Don't agree in relation to the US. Yes, the US can print currency and overinflate, but that will cause literally a civil war instantaneously. The US has no clue how to handle hyperinflation - only the Latam countries are experienced. Germany which faced it just after the World Wars carries scars so much in its psyche that even now, they are manically anti inflation. Theoretically its an option. Prctically it is impoossible to let it happen in the US. Theonly way is to reduce the debt.

@Gils - You raise a very important question. Why do countries borrow. They do so because they want to spend far more than what they earn. If the spending was on investment like education or health care or infrastructure, then borrowing is a valid option. If it is spent on doles, free TVs etc,it is madness. In the US after Clinton, you had a balanced budget and a manageable debt. George Bush reduced taxes, started two wars and expanded Medicare without caring for how to pay for it. result is the situation you are facing in the US now. Leaders have become irresponsible and spend without any restraint. That is why Germany is so admirable - they rarely spend beyond their means.

@Reflections - It is very scary. In Dubai, the same thing happened - they borrowed to build all the bling bling you see in Dubai and very nearly came to grief. I am of the opinion that you must have Rajalakshmi or Wang Xiao as finance ministers everywhere. These hardy women know how to live within their means.

Asha said...

Banks ask for surety from farmers, students and others who seek loan.on what basis are these countries offered loans, if they can't repay?

And this laon money is used for medicare and other subsidies, really? I thought they used the tax money. if it is tax money, they can do more for the aged and poor.

Ravi Rajagopalan said...

Well said. It is not clear what was the "right" thing to do - having restructured the debt and screwed the creditors, can two creditors claim they are more equal than others? The moral ramifications of this judgement will be heard loud and clear. Henceforth, no restructuring is safe.

I am oversimplifying, of course, but the unbridled expansion of international credit can be traced to the abandonment of Bretton Woods in 1971. President Nixon had to abandon the Gold Standard thanks to the slowing post-war boom and burgeoning costs of the Vietnam War.

There has to be a re-balancing, but that depends on how willing Joe Public is to understand economics.

Ravi Rajagopalan said...

And to add: This is not new either. IT has happened before.

Look at this URL:

Prats said...

Brilliant post... The implications of this cases are ridiculous. I mean imagine a situation where some leader from Argentina visits US and their plane is impounded for recovery. Once again I am stumped if US judicial system is fair or they are stupid.

Ramesh said...

@Asha - The surety is the "sovereign guarantee". Its that nations will never default since they have huge resources, unlike individuals or corporations. But, as we have seen, even sovereign guarantee is not an iron clad security.

Oh tax revenues fall far short of spending plans in virtually every country. So , almost everybody borrows.

@Ravi - Yes credit expansion did start with the abandonment of Bretton Woods. But all credit expansion is not bad. When borrowings go into investment (in Indian parlance - Plan Expenditure), then its very justified. The problem comes when borrowings go to doles, subsidies and wars which serve no productive purpose. Yes, it has happened many times in the past and has often led to invasions of the borrowing country by creditor countries.

@Prats - Thanks. In this one there is some justification for the courts intervening as the bond issues happened in the US. But there are many other frivolous cases brought against foreign governments in US courts. Those are a joke.

Vincy said...

As i was reading this post, i had similar questions that Gils has raised and inspite of the answers the question lingers.

Argentina seems to be making defaulting an habit without realising its Sovereignity is at stake. Isnt Argentina stealing its own future?

For all other countries who are in similar debt situations, Germans should be the role model and Argentina a wake up call.

Ravi Rajagopalan said...

@prats: This has already happened. A tall ship (i.e a ship with sails) belonging to the Argentine Navy was impounded at a port in Ghana by court order at the behest of these self-same two hedge funds. Worse, the port is charging the Argentine Navy $3m a day docking fees.

Ramesh said...

@Vincy - Yes, defaulters actually shoot themselves in their own foot. The problem is that the average citizen does not understand economics and its all too easy for political leaders to make an issue of sovereignty or nationalism and whitewash their economic mistakes.

The Million Miler said...

Hmmm at a much lower level, how many people fall prey to credit card debt. Banks send in gangsta type blokes to repossess whatever these sods might own. If you do it through a court it is OK, if it is done by gangster type hoodlums it is a crime. I fail to understand why people, companies or countries borrow beyond thier means. All I can think of is a quote attributed to Cicero in 55 BC (Obviously a bit doctored I guess to suit the times) "The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.” Have we learnt much in 2072 years? Not much evidently!

Sreekanth said...

While we can only marvel at the fiscal ineptitude of governments like Argentina... I cant but wonder what prompted the whizkids at the hedge funds to happily lend to these governments ? Weren't they aware of the risks they were taking in lending to country like Argentina ? How can they cry wolf now ? It's like a baddie in a Rajini movie buying insurance.. nothing good can come from it!

Ravi Rajagopalan said...

@Million Miler: Even if the quote is apocryphal, it is very true. That is what corrupted Rome. More recently, John Kay wrote in the FT that apparently Shah Jehan appropriated as much as 40% of India's GDP for his own use. We got the Taj Mahal but in two generations the Empire was gone.

Ramesh said...

@Kiwi - True, debt is a dangerous addiction at any level. That's a great quote.

@Sreekanth- Welcome to this blog and thanks for your comment. We have all been conditioned that sovereign debt is risk free. Nobody expected a government to default until Argentina did it in 2000. If we are wise, we will never buy any bond of the Maharashtra government, which is a bankrupt state, but we still do, believing no government will default.

sandhya sriram said...

i was just watching a video on teh flight on the american prime lending crisis. on how the government was pushed between devil and deep sea, at one end bailing out someone who just chose to erratically fool around with public money or face a financial collapse at the other end.

it was indeed quite interesting to watch the whole story, like a nice thriller movie. but what people are doing with public money all over is nothing less. as you say, it will bomb one day. maybe, Gils can make a thriller movie on Argentina one day with Ramesh playing the lead host.

PS: please cast the most beautiful argentinian lady as Ramesh's co-host. ok.

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