Did Argentina default on its bonds ?

It's actually a difficult question. The answer is yes - and no. So, why the ambiguous answer? Argentina does not pay interest and principal on the USD bonds issued under New York law, whereas they do pay interest and principal on bonds issued under local law.

Confused? A lot of people are confused about Argentinas' economy, politics and finances. And to be totally honest with you, it's a mess. 

President Cristina Kirchner

Let us start by looking at the public finances of Argentina. Cristina Kirchner was first elected president in 2007 and then reelected in 2011 for a second (and last) term which - by the way - ended yesterday. I will get back to this issue later this week. In 2007 the fiscal surplus was 0.7% of GNP. But, Cristina Kirchner increased public spending massively in her reign, especially driven by increases in pensions, social programs, energy subsidies and wages. So, it's no surprise that by 2015, the fiscal surplus had turned into a deficit of around 7% of GNP!  

All in all, primary spending increased from around 20% of GDP to around 45% by 2015. Note that this increase in spending and fiscal deficit has happened despite a record tax burden. 

Public spending skyrocketed on Cristina Kirchners watch. So what, you may ask: We have seen this happen over and over in emerging economies. So what if Argentina increase public spending and issue more debt to finance the deficit? But, that's it - they can't do that. Argentina - as a sovereign - is in effect barred from accessing the international capital markets. How did that happen ?

The case of the holdouts

I will digress for a bit and we have to go all the way back to 2001 where Argentina was in serious trouble and defaulted on it's debt. The government had to make a deal with the bond investors at the time. The government persuaded investors in 2005 and 2010 to accept a write down of the principal and an extension of the maturity of the debt. Investors would hand over their "old bonds" and get "new bonds" with worse terms, specifically a longer maturity and a reduced principal. Most investors accepted but some did not. In fact, approximately 7% of the holders of Argentine sovereign bonds did not accept the terms and became "holdouts". 

Originally, holdouts were international and Argentinian pension funds and asset managers hoping for a better deal from the government. Over time, several hedge funds found an interest in the old bonds and started buying them from the pension funds and asset managers. Over time, hedge funds became large holdout stakeholders. The best known hedge fund to do so, is probably Elliott Management founded by Paul Singer. 

Argentina made the decision not to pay interest on the old bonds but was indeed paying interest on the new bonds. It was basically a question abut ideology, Kirchner did not want to pay the "vulture funds" as she coined the holdout investors, even though Argentina did have the money to do so.

Why did the holdouts not accept the new bonds ? Well, they hoped to get a far better deal than the investors who accepted the original deal. By concentrating the ownership of the old bonds in the hands of few owners gave them leverage and Elliott Management filed a class action lawsuit against Argentina. The holdouts wanted Argentina to honor the debt on the old bonds as well.

It happens in New York

Historically, there has not been a lot of faith in the execution of law, order and justice in Argentina. So, in order to persuade international (and local) investors into buying argentina sovereign bonds, the government made the decision back in the 1970's to issue bonds under New York law. 

In the debt documents it says that "all bonds are equal". All bonds are pari passu which means that you cannot - as an issuer - differentiate between bonds: If you pay interest on one bond you are forced to pay interest on all bonds. 

Elliot Management filed a class action lawsuit against Argentina and made the case that if Argentina was paying interest on the new bonds, Argentina should also be paying interest on the old bonds (on original terms, of course). 

To avoid getting into too much detail here the outcome was a final loss for Argentina back in 2014 (after a long trial) and they were therefore forced to pay interest on the old bonds as well. There is more to the story ... and more legal mombo jumbo, like the RUFO clause that complicated things even further. If you have 10 minutes, you can take a look at this youtube video made by American Task Force Argentina. American Task Force Argentina is - it has to be said - payed for by parties interested in a favourable deal to the holdouts, but the video is overall a fair description of the events. 

Needless to say, President Kirchner still refused to pay interest on the holdout bonds (the old bonds), so by NY law it was impossible to pay interest on the new bonds as well. Argentina even tried to continue paying interest on the new bonds, but the NY law ruled against it, which is why Argentina defaulted on all of its NY law bonds. At the same time, there is a functioning market for USD bonds locally in Argentina ... and that market still works. 

Obviously, it you look at the lawsuit against Argentina from a capital markets point of view it is bad. Really bad. Essentially, one group of investors (the holdouts) are trying to have their way on the expense of the investors who accepted the deal back in 2005 and 2010. That is not sustainable. But, Argentina forgot to use collective action clause in the debt documents. Collective action clause means that all investors have to accept a restructuring deal if a certain minimum has already accepted the deal. If you dont have a collective action clause, you can end up having holdouts if the restructuring deal is not lucrative enough and that is precisely what has happened in this case.

Where does that leave Argentina ...

So, Argentina is shut out of international bond markets. They haven't been able to issue new bonds under New York law for some time now. At the same time President Kirchner has spent an awful lot of money and increased the fiscal deficit. So how did they manage to fund the deficit? By printing money - there is no other way around it. Printing money to fund the public deficit is going to create inflation. According to private estimates, inflation went from 10% in 2006 to an annual average of around 35% in 2013 - 2015. 

What is the way out of this mess ... it´s a new president ... and guess what, Argentina just got a new one yesterday!