Copyright 2002 Gale Group Inc. All rights reserved. COPYRIGHT 2002 Latin America Financial Publications, Inc./Tel: +44(0)207-779-8999/www.euromoneyplc.com Two Latin American sovereign defaults in two years have enraged lenders and jeopardized the health of the emerging markets asset class. What's more, Argentina's collapse and the 1999 Ecuadorian default have placed monumental strains on the negotiation process between markets and governments. Years of debate over crisis mitigation has yet to provide the world with a quick and clean debt restructuring that gives creditors a reasonable deal and allows sovereigns to return to the capital markets quickly and resume normal borrowing.

The discussion gained further impetus as Argentina sank into default last year and investors hardened their opposition to the government. Anne Krueger, the International Monetary Fund's first deputy managing director, had earlier proposed a negotiation and rehabilitation procedure for insolvent sovereign governments that would work rather like Chapter XI of the US bankruptcy code. Her suggestions made the headlines in the international business press but won her few friends in the financial markets. Bankers, rating agencies and lawyers ridiculed her plan. But at least Krueger was prepared to make some suggestions for filling what she calls a "hole" in the financial system. "We lack incentives to help countries with unsustainable debts to resolve them promptly and in an orderly way," she said. "At present, the only available mechanism requires the international community to bail out the private creditors."

Recurring sovereign financial crises have been a feature of Latin American financial markets for nearly 200 years and establishing a formal mechanism to process default in smooth and predictable, if not painless, way as possible makes sense. Latin American governments are the largest emerging markets borrowers and now that the world's financial system is fully interlinked, their problems can affect issuers and investors in all emerging market securities.

Walter Wriston, the former chairman of Citicorp, famously stated in 1982, a month after Mexico had defaulted on its foreign debts, that a "country does not go bankrupt." His comment, published in the New York Times, was widely ridiculed because it came at the outset of a series of debt crises in Latin America now remembered as the "Lost Decade."

However, Wriston (see "Harming, Rather Than Helping"), made an important point that was lost on most commentators at the time. Bankruptcy, he noted; is a "procedure developed in Western law to forgive the obligations of a person or a company that owes more than it has. Any country, however badly off, will `own' more than it `owes'. The catch is cash flow and the cure is sound programs and time to let them work."

It took Latin America and its creditors a decade to overcome the 1980s debt crisis. Since then, discussion over how to deal with countries that go bust was confined to academics, G-7 officials and staff at multilateral lenders like the World Bank and the IMF. In the last three months, though, the discussion has spread much further as investors, traders and bankers braced for Argentina's financial disintegration.

Managing default requires that everyone involved agree on a new payment schedule or principal reduction that a debtor can reasonably afford to service. It is anachronistic to imagine creditors taking over tax collection or their governments sending gunships to bombard Latin American capitals to enforce debt payments, as they did in the 19th century.

Detriment to All?

Many investors say Krueger's sovereign bankruptcy proposal is bad and needs to be resisted. They fear a new workout mechanism would damage their interests while defending those of the borrower, to the detriment of the emerging market asset class as a whole. Capital would stay away from markets where repayment is uncertain, driving up the cost of financing for borrowers in poor countries and depriving savers in rich countries of potentially attractive investments.

Michael Chamberlin, executive director of the Emerging Markets Traders Association, says, "The idea of sovereign bankruptcy is terrible. You look at how it would work and it starts falling apart, because of the nature of sovereignty. I do not hear anyone except for some loonies say that countries need to surrender sovereignty." Commercial bankruptcy processes require creditors to accept a reduction in their claims against a borrower and require debtors to sell assets or change their management. While courts could force creditors to accept a discount on their bonds, they cannot force a government to fire ministers or surrender control over tax collection. Therefore, says Chamberlin, "It is not fair to apply half of a bankruptcy process against one half and not on the other."

He likes the more modest, case-by-case approach that debtors and creditors must use by default given the absence of a formal bankruptcy code, and reach an agreement on their own. "People hate the case-by-case approach because it does not provide much intellectual comfort, but it works," he says. "Academics have the luxury of thinking up things that usually do not work, but law firms and investment banks and investors need to be more pragmatic."

But Krueger and her supporters in the public sector and academe think a formal mechanism would achieve three things. It would provide rapid rehabilitation for borrowers, eliminate moral hazard and deal with vulture funds. She argues that vultures interfere in debt reorganizations by holding out for better terms.

Krueger says a Chapter XI process would give sovereigns "legal protection from creditors that stand in the way of a necessary restructuring, in exchange for an obligation for the debtor to negotiate with its creditors in good faith and to put in place policies that would prevent a similar problem from arising in the future. The mere knowledge that such a framework was in place should encourage debtors and creditors to reach agreement of their own accord."

Mark Walker, partner at the New York law firm of Cleary, Gottlieb, Steen & Hamilton, says the IMF exaggerates the threat from vulture funds. Cleary represents Argentina in its negotiations with creditors and worked on behalf of Ecuador in 2000. Walker says countries have always managed to restructure their debts in spite of sniping from vulture funds. Walker, says countries do not avoid restructuring because of the costs of dealing with rebel bondholders as Krueger suggests. "I think [governments] shy away because the first stage in a crisis is denial," says Walker. As governments become aware of the magnitude of their problems, they try to avoid default and the economic, political and social dislocation it imposes on their country, not because they are worried about the depredations of a few vulture funds.

Yet he concedes that vulture funds could become more of a problem. Giving into them may be expedient if it ensures deals get done, but it does encourage other speculators. "If there are a handful of [them], just pay them off and that's that," says Walker. "But my concern is if that becomes a process. If enough people do this, then you can't get a deal."

He and others are more worried about the Fund's role. "The notion that the IMF would decide when a country is negotiating in good faith I find mind boggling. There are other ideas. It's not necessarily a bad idea to have a mechanism to allow creditors to resolve things on a consensual basis." Peter Geraghty, managing director at Darby Overseas Investment Corporation in Washington, says, "These guys will be lenders and they will also adjudicate. I say that it is difficult that they could be as unbiased as a bankruptcy judge."

The Right Thing

A well-designed bankruptcy process would eliminate moral hazard by making lenders and borrows pay for their mistakes by forcing them to accept a reduction in principal or interest payments. But the IMF and other public sector lenders would also have to reconsider their roles since they would probably have to surrender their status as senior creditors. The Fund would also have to devise new rescue packages for countries in trouble to eliminate any residual risk of moral hazard. The tradition of IMF-led bailouts, which began in Mexico in 1982, has ensured that governments can borrow from the Fund to repay their private-sector lenders in full. Some, such as Wriston think the IMF has outlived its usefulness and should close.

Joseph Stiglitz, the Nobel laureate and formerly the World Bank's chief economist, likes the idea of a bankruptcy code for countries. But he warned in an interview with Bloomberg in December that he wants "an independent agency, independent from either the creditor or the debtors, a neutral party, like a court. We really need some kind of world bankruptcy workout institution."

Although many people in the markets instinctively reject the idea of a Chapter XI process for governments and prefer to stick with ad hoc processes, some influential financiers are willing to think about how work out procedures could be made to function. Marc Helie, managing director at Gramercy Advisors, the New York investment management company that took a leading role in Ecuador debt negotiations, says it is important for investors to make their voices heard in a debate driven so far by academics and IMF officials. Helie says both the ad hoc and Chapter XI approaches have their limits, yet he and others in the markets are still thinking through how a more appropriate procedure would work.

In Latin America, the 1980s were marked by sovereign debt reschedulings, moratoria and abortive debt reduction plans that culminated in the creation of Brady bonds in 1989. That experience, and the defaults by Pakistan, Russia, Ukraine and Ecuador have created a store of knowledge on how to deal with defaults that should make future crises easier to cope with. In many cases, the lawyers, bankers and government officials who handled the post-1982 debt negotiations are still around. Argentina has hired Citigroup and Cleary, Gottlieb to handle its negotiations with creditors, the same law firm and banker as Ecuador used in 2000 that led to a rapid, if painful resolution to its debt crisis.

However, not everyone is happy with this arrangement. Bondholder activists rail against what they see as an alliance of debtor governments, international financial institutions and G-7 government officials willing to trample on investor rights in a bid to stabilize the world financial system. They complain that the Wall Street investment banks have no interest in working with bondholders because they fear this would compromise future mandates from Latin governments.

Investors complain that the IMF and G-7 governments have encouraged debtor governments such as Ecuador to renege on their bonded debt to ensure private sector "bailing-in" while requiring that these governments to repay official sector debt in full. One the first decisions by Adolfo Rodriguez Saa, briefly Argentine president, was to halt payment to foreign bondholders.

Bondholders and traders fume that this is just what Argentina promised not to do a decade ago, when it signed a Brady deal that restructured the country's commercial bank debt by converting it into bonds that supposedly would never be restructured. Bondholders hated how Ecuador and its advisors, required bondholders to sign exit consents that amended the rights of remaining Brady bondholders in order to qualify for the new, reduced value bonds. This made the old bonds so unattractive that investors would be compelled to exchange them.

Hans Humes, of Van Eck Global, a fund manager in New York, complains that this "waived all legal recourse and made the Bradys subordinate to the new bonds. Argentina will try to do the same thing."

This time, though, he vows bondholders will resist. "We have formed the Argentine Bondholders Committee and hired lawyers, and now there is dialog open with [Buenos Aires]. I think there is going to be a very big change between Ecuador and Argentina. The borrower has to show good faith. It can't be what we have seen before, where the international financial institutions and investment banks are working against the interests of bondholders. Anyone looking at Ecuador and thinking it was a good process is kidding themselves."

RELATED ARTICLE: Harming, rather than helping.

Walter Wriston, the former chairman of Citicorp, says that the IMF encourages governments to engage in misguided policies.

Walter Wriston is well into his 80s and it is 18 years since he retired as chairman of Citicorp. But he still goes to work at his office in the firm's New York headquarters every day. His views on international finance, which once seemed outlandish, have started gaining currency following the debacle in Argentina. Wriston advocates abolishing the International Monetary Fund, an organization he says has distorted the world's capital markets and helped financial crises erupt repeatedly.

"The IMF was created to iron out the bumps in a fixed exchange rate system and like any bureaucracy, when its mission has become irrelevant when rates started floating, it had to reinvent itself and began making interim loans in Latin America," he says. This spawned moral hazard by encouraging lenders to make reckless decisions because they were confident of being rescued whenever they get into trouble. "They [lent] on the expectation that someone would come in and bail them out and as long as the expectation goes on [crises] will go on," says Wriston. "If [the IMF] weren't around, countries would be better off." This is because the unforgiving discipline of the marketplace would not allow governments to indulge in misguided policies.

Soon, the IMF was in the business of advising governments on policy, and Wriston says this "created more trouble than it cured" because its policy prescriptions were flawed. The trouble with the Fund and its supporters, he claims, is that "they don't have faith in the marketplace. People do not see how strong the international financial market is." Crises do not threaten the basic health of the world's financial system.

Wriston denies any responsibility for the Latin American debt crises of the 1980s, preceded by years of gung-ho lending by banks to governments that could not repay their loans. He says, "We had a very sophisticated risk analysis system and it worked like a charm until inflation in the US hit 12% and [the Fed] locked wheels and all the exports from Latin America that were paying the debts stopped and we had the deepest recession since 1929." That pushed Latin America into default. It is paradoxical, he recalls, that "We were watching the wrong guys, the borrowers. It was our own Central Bank that caused the [debt crisis]." --J.B.