Default in Argentina?

[Louis Proyect <lnp3@xxxxxxxxx>]

July 11, 2001

Wall St. Considers Argentina's Default

By REUTERS

Filed at 9:29 a.m. ET

NEW YORK (Reuters) - As Argentine interest rates spiral higher the question
behind closed doors on Wall Street is not so much if Latin America's
biggest foreign borrower will default on its debt but when.

Those analysts who have been following the travails of Argentina are
hesitant to say publicly what they really believe: That in an environment
where the heavily indebted economy is contracting, the banking sector is
coming under pressure, global growth is sharply slowing and political
cohesion is frail, Argentine bond holders will some time this year be
forced to accept a debt restructuring.

``All of Wall Street is like the townspeople who are afraid to tell the
emperor he is not wearing any clothes because they're hoping to get a buck
from Argentina,'' said Charles Calomiris, a professor of finance and
economics at Columbia Business School, in reference to the more than $150
million in fees that some investment banks made from handling Argentina's
$29.5 billion voluntary debt swap last month.

One Wall Street banker who asked not to be named said right before
Argentina executed the bond swap, most investment houses had already
compiled spreadsheets analyzing default scenarios.

Calomiris said: ``Argentina has been in hopeless straits for several
months. The most likely scenario is that within a matter of months the
financial markets will cease participating in new debt auctions and then
there will be a disorderly restructuring of the country's debt.''

DAMAGE TO ONCE STRONG BANKING SECTOR

Privately, Wall Street says it is too far gone now for an orderly
restructuring, and that the longer Argentina's Economy Minister Domingo
Cavallo drags out the inevitable, the greater the damage to the once-strong
Argentine banking sector.

Banks seeking to fund themselves in the interbank market are having to pay
higher rates of interest than they can expect to receive from making
longer-term loans.

This is because Argentine banks that have obligations in dollars as well as
pesos have to hedge their currency risk through markets such as the
non-deliverable forwards market.

The implied yield on the mid-price of the non-deliverable forward one-month
contract, according to ING Barings, stands at 65 percent, reflecting the
growing perception in the market that Argentina may be forced to abandon
its one-to-one peg against the U.S. dollar.

Higher hedging costs mean the real cost of short-term funding for the banks
rockets.

``Argentina has spent 10 years making its banking systems one of the
strongest of emerging market economies,'' Calomiris said. ``But these banks
will be done in by the government's fiscal misbehavior.''

On Tuesday, the government was forced to pay investors participating in a
debt auction the highest interest rate in five years.

The differential between three-month NDF's and the Letes notes, a proxy for
the participating banks commitment to the auction, reached an all-time
high, according to Merrill Lynch (news/quote).

Spreads on Wednesday blew past 1,250 basis points over U.S. Treasuries. The
value of Argentina's portion of the J.P. Morgan Emerging Markets Bond Index
Plus has in one month lost 44 percent.

ACKNOWLEDGING DIFFICULTIES

While not everyone in the emerging markets world accepts restructuring as a
given fact, they do acknowledge the following difficulties that make
payment of Argentina's financial obligations difficult:

-- At $128 billion, or 45 percent of GDP, Argentina's debt burden is onerous.

-- The economy has contracted for 10 straight quarters. Most economists
cast doubt on Cavallo's prediction that the economy will grow 5 percent in
the last three months of 2001 compared to the same period in 2000. ING
Barings forecasts the economy to expand by 1 percent this year.

-- The global economy is flirting with recession. Compounded with a strong
U.S. dollar -- to which the Argentine peso is pegged -- Argentina's exports
remain uncompetitive.

-- With October elections fast approaching, political squabbling over
spending cuts between opposition Peronist governors and the federal
government undermines the country's ability to meet its International
Monetary Fund fiscal deficit target of $6.5 billion in 2001. ``Given that
the economy has not responded as expected to the government's efforts to
reduce the deficit and provide a sound basis for economic growth then it
could be necessary that the IMF relax somewhat this year's fiscal
targets,'' said Jaime Valdivia, emerging market debt strategist at Morgan
Stanley.

-- The IMF's decision to postpone a loan payment to Turkey signals the
international lender is taking a tougher stance when bailing out emerging
market nations.

-- Investors are demanding increasingly higher interest rates to justify
the risk involved in buying the country's debt. The price of the 2008
global bond has plummeted 14 percent since it was issued last month,
lifting the yield to 18.4 percent.

``You cannot operate an economy at the level where interest rates are right
now,'' said Mohamed El-Erian, fund manager at Pacific Investment Management
Co.

INDUCING CAPITAL FLIGHT

There are two ways Argentina could be forced to default on its debt,
according to El-Erian. In the first scenario, local banks would refuse to
continue rolling over domestic debt, inducing capital flight as Argentines
run to their banks to withdraw their savings.

And with the Convertibility Law that requires one dollar to be held in
reserves for every peso, money supply would severely contract. ``The
economy would implode,'' El-Erian said.

The second, and more tame default scenario, is where the government
initiates negotiations with the bondholders.

Analysts say the former scenario is the more likely one given Cavallo's
reputation in the market as arrogant and unwilling to accept defeat,
especially when he is eyeing the presidency so keenly at next year's
presidential elections.

Either way, once the government comes clean and admits it is in over its
head, bond prices themselves would collapse. Immediately after Russia
defaulted on its domestic debt in August 1998, bond prices halved and
yields soared.

Analysts say an across the board default would most likely ensue as
Argentina's external debt is linked through a cost default clause, which
means if the government defaults on one bond, a bondholder has the right to
accelerated payments on other bonds.


Louis Proyect
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