Argentina's newest proposal to reduce its debt burden might lead to a default that could make it very difficult for emerging market countries to borrow in the future.
So far, there have not been too many ripples beyond the impact on Argentina's neighbor, Brazil.
But the longer-term outlook depends a lot on how the debt is restructured to lower Argentina's financial burden and whether investors are forced to accept a package they are unhappy with.
Problems with the restructuring program are already appearing.
"In the short run, this has been telegraphed so long that the knock-on effect is going to be muted," said Carl Ross, senior managing director for emerging markets at Bear Stearns. "I am concerned about the long-term contagion. If Argentina defaults, there will not be an immediate cascading of countries defaulting. But over time there could be.
"In the future," he said, "countries looking at Argentina's experience might conclude that if this is where we are going to end up anyway, why put our populations through the pain?" Argentina has already suffered through four years of recession and large budget cuts to meet its debt payments.
The issue of whether Argentina defaults during its effort to restructure as much as US$95 billion in bonds held by Argentine banks and institutions and foreigners is complicated by the definition of what is a default. But a restructuring that leaves many investors unhappy with the deal will not be positive, Ross said.
One investor in emerging market debt said that a drawn out and messy restructuring of Argentina's debt, especially if it were repeated in other countries, could dry up the lending pool for emerging market countries.
Argentina faces other tough problems that could undermine its effort to reach a deal with its creditors. Problems include declining tax revenue as the global economic slowdown drags Argentina's economy lower; the need to meet a zero deficit target to comply with terms for additional aid from the International Monetary Fund; difficult negotiations with the country's provinces on cutting spending; the withdrawal of money from the banking system by frightened depositors; and obtaining the additional cash needed to offer its creditors a debt swap that is attractive to them while also reducing the country's debt burden enough to ease the pressure on the government and the economy.
Beyond all of that, any recovery for Argentina depends on turning the economy around, a task that has become even more difficult since the terrorist attack on the US.
"There is a lot of uncertainty right now," said Joyce Chang, global manager of international fixed-income research at J.P. Morgan. She said that the prices of Argentina's bonds in the market already showed that investors "are pricing in an effective default."
The fact that the fallout from the current stage of Argentina's crisis has been limited is seen in the performance of bond prices this week. While Argentina's floating rate bond maturing in 2005 fell 17.5 points, or 27.6 percent, to US$46, the popular Brazilian C bond maturing in 2014 dropped just 1.75 points, or 2.5 percent.
Bond prices in the rest of Latin America fell even less, with a popular bond in Mexico down just three-tenths of a point. And the Brazilian real, which has fallen 27 percent this year as the Argentine crisis deepened, has been in a mild rally since Sept. 21, rising 6 percent.
One reason for the moderate reaction is that many investors have already pulled out of Argentina and the countries they think could be hurt by its crisis. In addition, there are fewer big bettors in emerging markets since Russia defaulted on its debt in 1998.
Four large US banks have significant exposure to Argentine and other Latin American debt, and a new Lehman Brothers analysis says they "have been under pressure on renewed concerns about Argentina's debt woes." The four are FleetBoston, Citigroup, Bank of America and J.P. Morgan Chase.
Lehman Brothers said that FleetBoston's Latin American loans accounted for about 10 percent of net income and noted that Citigroup said in the second quarter that Argentine loans contributed less than 2 percent to earnings. J.P. Morgan Chase and Bank of America each have about US$900 million in loans in Argentina.
Problems with Argentina's plan to reduce its debt burden arose as soon as the country issued the barest of details. In a statement of economic policy changes to deal with the crisis, the government said Thursday that it wanted to save about US$4 billion a year in debt service costs by cutting the aggregate interest rate on its debt to 7 percent from about 11 percent now. That is a reduction of nearly 40 percent. In exchange, the government has said it will offer guarantees of payment of principle and interest.
"It is difficult to believe that they have enough credit enhancements to go from 11 percent to 7 percent," Ross of Bear Stearns said, referring to the sweeteners the government would need to offer investors. "This is why the market is a little confused right now."
Because there are no details, investors are assuming a debt restructuring would be something like the famous Brady bonds used in the late 1980s and early 1990s to restructure Latin American debt, including that of Argentina. All those deals included significant debt reduction in exchange for guarantees of principle and interest payments.
The trader in emerging market debt who asked not to be named said there was a 50 percent chance now that the restructuring of Argentina's debt would be "a long, drawn out messy process."
On the issue of default, the major credit rating agencies have already indicated that they will give a default rating to the new bonds in a debt exchange like the one Argentina is contemplating. That is because the value of the new bonds will be less than the value of the old bonds. A legal default, according to analysts, is more complicated, requiring a triggering event, like missing an interest or principle payment, followed by a vote of a majority or more of the bondholders to force the default.
Argentina says that it wants its exchange to be voluntary and that if enough bondholders agree to it, a legal default could be avoided, analysts said. But there will be a lot of pressure on investors, including banks and pension funds in Argentina, to agree, so a voluntary agreement may be less voluntary than it appears. And one may not be able to be reached.
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