Latin Finance - May 2008 - 112

Parting shot fact that high commodity prices have given the leaders of these countries the ability to service their debts and distribute the governmental largesse necessary to keep themselves in good odor with the electorate. But what happens if the prices for those commodities return to something resembling their historic norms? Will the populist rhetoric about paying the “social debt” before the “financial debt” be transformed into concrete action? And once one country incurs the opprobrium of a politically-driven debt default, might not philosophically-aligned politicians in other countries decide that they have the cover to do likewise? It may be a particularly hazardous moment to make predictions about the international financial markets, but there does not appear to be a serious risk of a contagious sovereign debt problem on the immediate horizon. The proximate cause of the global debt crisis that began in 1982 was the confluence of two factors – a drop in the price of primary commodity exports (principally oil), with a concurrent sharp rise in interest rates. For oil exporters burdened by tens of billions of dollars of floating rate bank debt, this proved to be a lethal combination. The main risk today may be a drop in commodity prices if the economies of the developed world, plus China and India, begin to slow down. But the effect of any rise in long-term interest rates will be muted by the fact that the debt stocks of many EM countries have been reduced to manageable levels, are increasingly denominated in local currencies and often carry fixed rates of interest. Systematic crises aside, individual countries may, and almost certainly will, face debt difficulties from time to time. The causes may be wholly external, such as the devastation wrought in Grenada by Hurricane Ivan in September 2004. Or possibly the rhetoric of a populist politician may paint a country into a corner where an external debt default becomes a domestic political imperative, even if it lacks any compelling economic justification. Finally, old-fashioned mismanagement of a country’s finances – the product of incompetence, corruption or misplaced trust in the perpetual benignity of market conditions – will occasionally force debt rearrangement. behave in a responsible manner if they are given the information necessary for them to conclude that the rearrangement being sought is indeed necessary in light of the sovereign’s situation, that the debt relief being requested is proportional to the debtor’s needs and that other stakeholders are bearing an equitable share of pain. Derivatives Surprises That said, future sovereign debt workouts will undoubtedly hold some surprises. We have not, for example, even begun to grasp how the existence of derivative instruments such as credit default swaps, will change the dynamics of future sovereign debt restructurings. If the Republic of Ruritania starts slipping into a debt crisis in the year 2010, the purchasers of credit default swap (CDS) protection on Ruritania – some of them creditors of the country but many just speculators – will be hoping the crisis will intensify to the point of an outright “failure to pay” on Ruritanian external debt. Some of these players may be quietly urging the Ruritanian authorities to suspend debt payments (“a ‘moratorium,’ Minister, if you please”) for a period lasting at least one day longer than the grace period on Ruritania’s bonds. Why? Because on that day their CDS protection will be callable. The sellers of that CDS protection will then be obliged to purchase from their CDS counterparties, at full face value, Ruritanian debt instruments having a market value less, perhaps far less, than 100 cents on the dollar. These derivative instruments will change the dynamics of the debt workouts in important ways. For one thing, imagine the confusion of the Ruritanian financial authorities when they are told that a significant part of “the market” would positively rejoice at a Ruritanian debt default. No finance minister of the 1980s ever had to confront this phenomenon. In those simpler days, the following equation was invariably correct: creditor = someone who does not want to see a default. Second, sovereign debt restructurings are always easier if a significant period of time elapses between the advance of a credit and the need to restructure that credit. The individuals who made the initial credit decision will probably be gone, thus dampening the lender’s emotional reaction to the realization that the credit decision was flawed. In addition, the widespread practice of marking investments to their market value on a daily basis means that the decline of the sovereign’s economic fortunes leading up to the restructuring will probably have been matched by a gradual deflation of the value of the paper on the creditors’ books. When the announcement of the debt restructuring eventually comes, therefore, the creditors will have already absorbed the related accounting pain, or much of it. Ruritania in 2010 cannot expect to benefit from such an attenuation of the emotional and accounting shock of a debt default. On the day after the grace period expires on Ruritania’s debt instruments, a significant part of the country’s creditor universe will churn. The new owners of the instruments will be the former sellers of CDS protection on Ruritania. And they will have acquired the defaulted credits at 100 cents on the dollar – just yesterday. The bad credit decisions will therefore be raw; the culpable individuals will still be walking the halls of the new owners of the debts; the accounting shock will be sudden and unpleasant; and everybody will be furious with Ruritania for not having been able to restructure its debts (like Uruguay did in 2003) before an outright payment default became necessary. In that autumnal environment, the restructuring of Ruritania’s external debt stock will commence. LF The Techniques So, will a Merciful Providence suddenly deprive his sovereign debt restructurers of employment? Unlikely. But this leaves the question of how future debt workouts will be conducted. On this topic a degree of optimism may be warranted. There have been a dozen or so sovereign debt restructurings since the first sovereign bond workouts began in 1999, enough to permit some general observations on trends. With one possible exception (which I acknowledge some readers may regard as an Himalayan exception), these debt restructurings have: 1) Moved along at a brisk pace. On average, it has taken significantly less time to complete sovereign debt restructurings in this century than it did to negotiate, launch and close the Brady restructurings of the early 1990s or the commercial bank loan reschedulings of the 1980s. 2) Showed that sovereign debtors and the majority of their private creditors can work together in a cooperative manner despite their seemingly antipodal interests. 3) Confirmed a lingering suspicion that the behavior of vulture creditors victimizes the other lenders caught up in the process just as much as it does the sovereign debtors. 4) Demonstrated that an efficient debt rearrangement can be concluded even when the creditor group is vast and heterogeneous. 5) Underscored the lesson that the sovereign debtor always carries the burden of persuasion when approaching its external creditors for a rearrangement of its debt obligations. Creditors, or most of them, will *Lee C. Buchheit is a partner at Cleary Gottlieb Steen & Hamilton in New York and a veteran of many high profile LatAm restructurings. 112 LATINFINANCE May 2008

Latin Finance - May 2008

Table of Contents for the Digital Edition of Latin Finance - May 2008