Argentina’s Griesafault

Joseph E. Stiglitz, Martin Guzman

AUG 7, 2014
Argentina Flag

NEW YORK On July 30, Argentina’s creditors did not receive their semiannual payment on the bonds that were restructured after the country’s last default in 2001. Argentina had deposited $539 million in the Bank of New York Mellon a few days before. But the bank could not transfer the funds to the creditors: US federal judge Thomas Griesa had ordered that Argentina could not pay the creditors who had accepted its restructuring until it fully paidincluding past interestthose who had rejected it.

It was the first time in history that a country was willing and able to pay its creditors, but was blocked by a judge from doing so. The media called it a default by Argentina, but the Twitter hashtag #Griesafault was much more accurate. Argentina has fulfilled its obligations to its citizens and to the creditors who accepted its restructuring. Griesa’s ruling, however, encourages usurious behavior, threatens the functioning of international financial markets, and defies a basic tenet of modern capitalism: insolvent debtors need a fresh start.

Sovereign defaults are common events with many causes. For Argentina, the path to its 2001 default started with the ballooning of its sovereign debt in the 1990s, which occurred alongside neoliberalWashington Consensuseconomic reforms that creditors believed would enrich the country. The experiment failed, and the country suffered a deep economic and social crisis, with a recession that lasted from 1998 to 2002. By the end, a record-high 57.5% of Argentinians were in poverty, and the unemployment rate skyrocketed to 20.8%.

Argentina restructured its debt in two rounds of negotiations, in 2005 and 2010. More than 92% of creditors accepted the new deal, and received exchanged bonds and GDP-indexed bonds. It worked out well for both Argentina and those who accepted the restructuring. The economy soared, so the GDP-indexed bonds paid off handsomely.

But so-called vulture investors saw an opportunity to make even larger profits. The vultures were neither long-term investors in Argentina nor the optimists who believed that Washington Consensus policies would work. They were simply speculators who swooped in after the 2001 default and bought up bonds for a fraction of their face value from panicky investors

They then sued Argentina to obtain 100% of that value. NML Capital, a subsidiary of the hedge fund Elliot Management, headed by Paul Singer, spent $48 million on bonds in 2008; thanks to Griesa’s ruling, NML Capital should now receive $832 million – a return of more than 1,600%.

The figures are so high in part because the vultures seek to earn past interest, which, for some securities, includes a country-risk premium – the higher interest rate offered when they were issued to offset the larger perceived probability of default. Griesa found that this was reasonable

Economically, though, it makes no sense. When a country pays a risk premium on its debt, it means that default is a possibility. But if a court rules that a country always must repay the debt, there is no default risk to be compensated.

Repayment on Griesa’s terms would devastate Argentina’s economy. NML Capital and the other vultures comprise just 1% of the creditors, but would receive a total of $1.5 billion. Other holdouts (6.6% of total creditors) would receive $15 billion. And, because the debt restructuring stipulated that all of the creditors who accepted it could demand the same terms as holdouts receive, Argentina might be on the hook for $140 billion more.

Every Argentine might thus owe more than $3,500more than one-third of average annual per capita income. In the United States, applying the equivalent proportion would mean forcing every citizen to pay roughly $20,000all to line the pockets of some billionaires, intent on wringing the country dry.

What’s more, the existence of credit default swaps creates the possibility of further gains for the vultures. A CDS insures against a default, paying off if the bonds do not. They can yield substantial returns, regardless of whether the bonds are repaid – thus reducing their holders’ incentive to achieve an agreement.

In the run-up to July 30, the vultures conducted a scare campaign. A second default in 13 years would be a big setback for Argentina, they claimed, threatening the country’s fragile economy. But all of this presumed that financial markets would not distinguish between a default and a Griesafault. Fortunately, they did: Interest rates for different categories of Argentine corporate loans have not reacted to the event. In fact, borrowing costs on July 30 were lower than the average for the whole year.

Ultimately, though, the Griesafault will carry a high price less for Argentina than for the global economy and countries needing access to foreign financing. America will suffer, too. Its courts have been a travesty: As one observer pointed out,it was clear that Griesa never really fathomed the issue’s complexity. The US financial system, already practiced at exploiting poor Americans, has extended its efforts globally. Sovereign borrowers will not – and should nottrust the fairness and competence of the US judiciary. The market for issuance of such bonds will move elsewhere

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, was Chairman of President Bill Clinton’s Council of Economic Advisers and served as Senior Vice President and Chief Economist of the World Bank. His most recent book, co-authored with Bruce Greenwald, is Creating a Learning Society: A New Approach to Growth, Development, and Social Progress.
Martin Guzman is a postdoctoral research fellow at the Department of Economics and Finance at Columbia University Business School.

Markets Insight

August 7, 2014 5:58 am

Risk culture must change to protect financial system

Key causes of past crises are being forgotten

Financial firms are dialling up risk in their search for yield due to the extraordinary amounts of liquidity created by central banks, and the prolonged low-rate environment. This is often not being done prudently; the key causes of past financial crises are being forgotten at many financial institutions.

Senior managers and boards at such institutions need to put more emphasis on risk management and risk culture; some may not do so. Regulators and supervisors should also press financial firms to focus more directly on risk management culture, and institute changes in this area. Their ability to do this may be compromised by their focus on the quantitative issues of capital and liquidity, frequently at the expense of the no less important qualitative matter of risk culture and behaviour.

New examples of imprudent risk behaviour arise almost daily. The Financial Times has noted the rapid rise of subprime lending in the US to finance used car purchases by non-creditworthy customers. Another warning signal was the statement by the Bank for International Settlements that 40 per cent of syndicated loans are to subinvestment-grade borrowers, a greater ratio than was seen in 2007.

Soaraway values

More broadly, the valuation gains seen in the equity markets, the prime real estate markets and at the leading art auctions bear little relationship to fundamental economic developments. These asset values are soaring, while world trade is stagnating. There is scant real growth across most of the eurozone and in Japan. US growth over the past 12 months has been less than 2 per cent, yet in the same period the S&P 500 stock market index, for example, gained about 17 per cent.

In the same vein, corporate emerging market debt has expanded by close to five times since 2008. This is far in excess of the real growth of emerging market economies, some of which are performing poorly and are more vulnerable to any future changes in monetary policies.

While China’s economy does appear to be growing in line with the government’s objective of 7.5 per cent, this is due in large part to increased levels of credit growth. As a result, bubbles are surfacing in the hot property markets. The shadow banking system is also expanding rapidly and is only lightly regulated, while mainstream banks continue to maintain high lending levels to state-owned enterprises and municipalities.

On a global basis, managers of some financial companies are not sufficiently curbing imprudent risk-taking. To some degree they feel the competitive pressures to consistently produce better quarterly results. At the same time, many management and board risk committees are still not properly equipped to oversee risk management and to change the prevailing culture.

Another serious concern is that in the eurozone the European Central Bank will be focusing on key capital, liquidity and other metrics, while paying insufficient attention to risk behaviour, as it conducts stress tests of major banks.

UK and US authorities, meanwhile, have become increasingly concerned about specific issues of banking misconduct. These are serious, to be sure, but there is insufficient focus on the broader issues related to the current reach for yield that could pose future systemic threats.

Fed must lead

The US Federal Reserve has a crucial role here. Richard Fisher, president of the Dallas Federal Reserve Bank, said in a recent speech: “I believe we are experiencing financial excess that is of our own making. When money is dirt cheap and ubiquitous, it is in the nature of financial operators to reach for yield.”

Mr Fisher is right and the Fed should use its powers to press the leaders of US banks to promote prudence in risk-taking as a core cultural value. Given that about 75 per cent of the US capital market is in the hands of non-bank institutions it is important that the Securities and Exchange Commission and the Commodity Futures Trading Commission join the Fed in publicly (and privately) calling for proper risk behaviour.

Jointly, leaders of financial institutions and their regulators in the US, UK, Japan, the eurozone and China should now emphasise the crucial importance of risk management and risk culture. They should come together to candidly exchange views and explore ways to channel risk activities on to a surer course.

There are no simple remedies, and changing culture in institutions always poses challenges. But it is vital that actions are taken before a financial crisis materialises to recognise that proper risk behaviour truly matters to the safety and soundness of the financial system.

William R Rhodes is president and chief executive of William R Rhodes Global Advisors and author of “Banker to the World: Leadership Lessons from the Front Lines of Global Finance”

Copyright The Financial Times Limited 2014.

Last updated: August 7, 2014 8:22 pm

Mario Draghi says eurozone recovery is on track

ECB president Mario Draghi©EPA
ECB president Mario Draghi

European Central Bank president Mario Draghi has insisted that the eurozone’s recovery remains on track, despite acknowledging threats to growth had “heightened” because of crises in Ukraine and the Middle East.

The ECB kept rates on hold for a second consecutive month and offered no hint that it had moved closer to embarking on broad-based asset purchases, known as quantitative easing.

Mr Draghi acknowledged that eurozone momentum had weakened in the second quarter and a rise in political tensions would inflict more damage. But he maintained that a weak recovery would continue and longer-term inflation expectations remained anchored to the central bank’s target of below but near 2 per cent.

The ECB president urged governments to boost the recovery, blaming a lack of labour market reform and excessive business regulations in Italy for the eurozone’s third-biggest economy returning to recession. Mr Draghi also countered calls from François Hollande, France’s president, for more central bank action, saying it would do little unless Paris tackled structural economic flaws.

Gilles Moec, of Deutsche Bank, said Mr Draghi’s remarks suggested that “governments should focus on their own shortcomings rather than asking the ECB for more.”

Mr Draghi said monetary policy would provide more support in the months ahead as measures announced in June took full effect.

The central bank will next month hold the first of six targeted longer-term refinancing operations, which require banks to sign up to commitments on lending and are widely seen as the most important strand of the June package.

Market estimates of a “sizeabletake-up of the offer of cheap, fixed-rate, four-year loans, of between €450bn and €850bn of a possible €1tn, were confirmed by the ECB president.

The euro, which has fallen more than 2 per cent against the dollar since the start of June to $1.335, was likely to depreciate further, supporting eurozone companies by lowering the price of their products against competitors outside the currency area.

Markets have perceived that . . . monetary policies in the euro [area] and the United States are, and are going to stay, on a diverging path,” Mr Draghi said. “The fundamentals for a weaker exchange rate are much better than they were two or three months ago.”

The US central bank is expected to stop buying US Treasuries in the autumn and to raise rates towards the middle of next year.

Europeans are braced for a new age of austerity as governments across the region take action to eliminate unsustainable budget deficits.

The ECB on Thursday kept its main refinancing rate at 0.15 per cent and its deposit rate in negative territory, continuing to charge 0.1 per cent on a portion of banks’ reserves parked at the ECB.

The council reiterated that rates would remain at their current record low levels for an “extended period”. Economists do not expect the central bank to raise borrowing costs at least until the end of 2016.

The ECB will shortly hire a consultant to design a programme for possible purchases of asset-backed securities, a move the central bank hopes will aid lending across the bloc by reviving the dormant securitisation market.

Inflation fell to a fresh four and a half year low of 0.4 per cent in July, less than a quarter of the ECB’s target. Eurozone gross domestic product figures, due out next week, are expected to show growth was as weak in the three months to June as in the opening quarter.

But, without an escalation in political tensions or a major economic shock, the ECB is not expected to take any additional action at least until December, with policy makers preferring to gauge the impact of the June measures before deciding whether to act again.

The central bank president said the collapse of Portuguese lender Banco Espirito Santos was unlikely to require taxpayer funds or inflict significant damage on the health of the eurozone area’s financial system.

Additional reporting by Stephen Smith.

Copyright The Financial Times Limited 2014.