Why Argentina should do its bond exchange, ASAP

Yields on Latin American bonds have not been this low for a long time. It is hard to believe that Brazil’s 20 year dollar bond trades at a yield of only 8%, and most long-term Brazilian bonds are in the 8-9% range. Brazil’s economy is growing strongly this year, but its gross debt is still quite large.

The broad rally in Latin bonds means the cash flow that Argentina put on the table in the summer is now judged to be worth a lot more by the market than it was some time ago. That is good for Argentina, and increases the chances Argentina will put its default behind it, and complete the biggest restructuring of emerging market bonds ever. The gap between Argentina’s offer and the market price has closed -- even though the actual amounts Argentina is offering to pay have not changed much since the summer. JP Morgan reports that the implied discount rate (yield) on Argentina’s new bonds is around 10.25%, 150 basis points (1.5%) above the yield on a comparable Brazilian bond. Back in the summer, the expected discount rate was closer to 12%.

A warning: this post is not only long but not about the dollar or the US. At least in theory, I know more about sovereign debt restructuring than I do about currency markets ... so I want to work in a bit more emerging market commentary into the blog, but no doubt this post will not be of interest to many.

My advice to Argentina is simple. Do the deal now, and if you cannot do it now, do it as soon as you can, even if it costs a bit more -- not because it is good for bond investors, but because it is good for Argentina. Back in 2001, before its default, Argentina promised investors a yield of over 15% or so to convince them to defer payments. That was a stupid deal -- Argentina had too much debt, and could not afford to pay such a high rate to defer payments. Now, after its default, investors seem willing to discount Argentina’s future cash flows at a rate of close to 10%. In a debt exchange, a country effectively sells new debt to retire its old debt, and right now is a good time for any emerging economy, even one if default, to be selling debt.

More unsolicited advice for Argentina: don’t be penny wise and pound foolish. You have cash on hand right now, cash that could be used to provide that little extra something that could generate a high level of participation in the exchange. There is a sense in the market that the rally in emerging market bonds (and thus the value of Argentina’s existing offer) has reduced the prospects that Argentina will sweeten its offer. Maybe. But I think Argentina’s interest -- properly defined, though perhaps not as defined by Argentina’s president -- is still to put a bit more on the table at the last minute. An offer that clearly is a bit above the bonds have traded for the past year or so (@ 30 cents on the dollar) might generate much higher than expected participation, and save Argentina legal expenses down the road (Sorry, Cleary).

President Kirchner can still take credit for negotiating hard, for getting substantial relief for Argentina and for timing the market almost perfectly. Argentina won big by waiting until now to do a deal. Kirchner should be able to make that case domestically -- he should not take much political heat if he improves the deal at the margins.

Argentina’s sound fiscal policies deserve some of the credit for Argentina’s potential low exit yields. "Populist" Kirchner does not sweet talk the international bond market, but he has delivered fiscal results that -- after an exchange -- should allow Argentina to make real payments on its new bonds. Argentina refused a primary surplus of more than 3% in negotiations with the IMF, and then went out and ran a primary surplus that looks to be more than 5% of GDP.

Former President Menem knew how to say what the bond market wanted to hear, but Menem tended to issue new bonds to pay the interest on Argentina’s existing bonds, even in good times. Rhetoric matters, but so do results -- and Kirchner’s fiscal record to date has been stellar, by Argentine standards. So far, Kirchner has made payments on Argentina’s performing debt out of Argentina’s fiscal surplus. That does not do bondholders any good if Argentina is not paying them, but that changes the moment payments start. An exchange won’t eliminate the need for sound fiscal policies.

One features of recent sovereign defaults -- in Russia as well as Argentina -- is that fiscal policy tends to be a lot better after the default than before it. For all the talk of "market discipline," the discipline that comes from not having access to the market seems to be a bit stronger.

Two other points.

First, a deal that promises bondholders too much is not obviously in the interest of Argentina’s bondholders, at least not in their longer term interest. Bond holders can win, obviously, if Argentina promises to pay a lot over time. But if the market discounts that promise to pay at a high rate, the cash flow in the out years does not necessarily add a lot to the bond’s present value, which is what the market cares about. Bondholders can also win over time if Argentina makes promises to pay a smaller amount, and the market concludes that promise is credible and so the bond should trade a low discount. That is what happened in Russia: falling spreads on Russia’s long bond (now around 300 bp above Treasuries) have driven its price way, way up since Russia’s 2000 restructuring.

If you promise too much, that kind of rally is not guaranteed: Ecuador resumed payments after its default in 2000 and the global environment has been kind to all oil exporter, but the cash flow on Ecuador’s bonds currently is discounted at a rate of over 11% (using early December data). Ecuador’s bonds likely will trade at a higher spread than Argentina’s bonds from the moment Argentina’s bonds are issued. Why? Because of Ecuador’s current politics, no doubt, but also because paying a coupon of around 10% on its roughly $4 billion in international bonds is not clearly in Ecuador’s political and economic interest should oil prices fall. That leaves Ecuador’s bondholders in a fundamentally precarious position. $400 million is about 1.3% of Ecuador’s GDP -- a substantial net transfer. The European Union’s budget for internal European transfers is of equal size. Ecuador can afford that kind of payment when oil is high, but market righly seems to doubt Ecuador’s ability and willingness to make that sort of net transfer should oil fall sharply/ Ecuador’s economy start to shrink.

Second, Argentina’s debt to GDP ratio will still be close to 80% even if it secures a deal on its proposed terms. Interest payments on its external debt are modest initially, so Argentina just might be able to grow out of its debt and break free from its cycle of serial default (What Ken Rogoff has called debt intolerance).

To do so, Argentina will have to maintain its current sound fiscal policies even as growth slows. Think Russia after 1999. It will also need to rebuild its domestic banking system on stronger foundations. The local banks currently hold lots of government debt that only pays a 2% real rate. That only works so long as local deposit rates are kept extremely low. But US rates are likely to rise, and the Argentina’s central bank won’t be able to fight peso appreciation forever -- so domestic Argentine rates are likely to rise too. Argentines are willing to accept low peso rates in part because they expect the peso to appreciate over time. Argentina -- and its international bondholders -- should expect that Argentina will have to pay more on its domestic debt over time. That is one important reason why Argentina truely cannot afford to pay as much as some bondholders have been seeking.