Would Argentina Be Better Served By Partial Default And General Restructuring?

In corporate finance, one strand of theory deals with the nature of distressed firms. Companies fail for one of two reasons: bad operating policies or bad financial policies. The savvy investors are those who can recognize opportunities to reorganize profitably the operations or capital structure of failing companies with otherwise healthy prospects. The levers often pulled include changing the management, reducing overhead expenses, eliminating internal economic distortions and replacing debt with some combination of debt, equity and warrants. The objective here is to resume growth in positive cash flows in a fair and equitable manner. The question that I will address is whether or not such an approach, albeit one suited for a country, would be productive in the case of Argentina, as the country is described in “Cavallo’s Crunch.”[1]

Is A Financial Restructuring Necessary?

Argentina has $128 billion in sovereign debt (much of it dollar-denominated), debt that was recently downgraded by S&P to Single B. As an indication of its risk, consider the fact that the “Argentine portion of the JP Morgan Chase EMBI+ index” trades at roughly 1,000 bps above US Treasuries.[2] Growth is broadly anemic and economic sentiment is overtly pessimistic. April vehicle sales were down 37.3% year-over-year (yoy), March industrial production fell (for the eighth consecutive month) at 6% yoy, March cement sales fell 13.9% yoy, and private deposits have fallen by 6.3% since the resignation of Cavallo’s predecessor on March 2.[3] Against this backdrop, Cavallo has announced new taxes and spending cuts, in order to maintain access to IMF funding facilities ($40 bio promised in January) and to help persuade banks with short-term debt to swap that debt into 20-year and 30-year bonds. The oft-bandied argument that the IMF’s readiness to bailout otherwise insupportable regimes constitutes a moral hazard may be justified in the case of Argentina. By not allowing Argentina to fail quickly and decisively, the IMF’s actions mean that Argentinians are suffering the death of a thousand cuts: a vicious cycle in which growth weakens, tax revenues fall, tax rates are increased and spending is cut, leading to lower growth.

Cavallo May Be Positioning Himself To Change The Management Team

Successfully addressing Argentine political risk is a critical factor in the prospective turnaround of Argentina. The article suggests that Cavallo will face a “political row at home” if he divulges too much detail about his proposed spending cuts. If Argentina’s growth continues to fail, requiring the deepening of such cuts, the problem is only going to get worse. One theory for Cavallo’s behavior is that he is using the current strategy as a transitional one in order to stabilize his power. Why? Argentina will hold Congressional elections in October 2001 in which all of the seats in the upper house and half of the seats in the lower house will be contested.[4] Moreover, Cavallo is rumored himself to be interested in the job of President. If he is seen to be the natural, indispensable leader through the economic crisis, he is well set-up for that election and he is poised to influence the Congressional elections tremendously. He has already demonstrated a willingness to exercise power in the contrived departure of antithetical central bank governor Pou.

Is There Room To Cut Overhead Expenses?

In the most recently announced budget, Cavallo announced spending cuts of $900 mm, mainly coming from a reduction in discretionary spending and from greater efficiencies in the social security administration. It is not clear from the article or from other sources whether there is further room to maneuver on the fiscal front in the years to come. This situation will only be made worse by a weakening of the economy that would require cyclical stabilization spending.

Are There Internal Economic Distortions Impeding Growth?

What is most disturbing about Argentina’s future prospects for growth are the economic distortions already present in the economy and the ones that Cavallo is seeking to extend in his latest budget. These include a new financial transactions tax of 0.25%, an increase in import tariffs on consumer goods, an extension of the capital gains tax and a broadening of the Value Added Tax base.[5] The financial transactions tax and the capital gains tax will distort investment in the sense that investment capital will be less likely to be redeployed to its most economically useful aim, quickly. Poor investments may stay invested longer, for example. The tariff on consumer goods, ostensibly to protect forever-nascent local industries, will make these companies ultimately weaker for not having had the opportunity to hardy themselves with a fully organic global competition. The VAT may discourage consumer spending that jeopardizes Cavallo’s putative virtuous cycle of growth[6] in which investor confidence and consumer sentiment is raised, consumers start to spend, leading companies to invest, further raising confidence and sentiment.[7] This is not to mention the significant distortions that exist in the labor market and the effect of the real devaluations of its major trading partners, like Brazil.

What Would A Restructuring Of Argentine Debt Look Like?

In a corporate restructuring, debt is exchanged for a combination of new debt, equity and warrants. What is the equity for a country, though? One could make the argument that a country’s equity could be represented by a freely floating exchange rate. Would it be possible to compensate existing bondholders with a combination of new, longer-maturity debt and longer-dated (five to fifteen year) out-of-the-money calls on a freshly devalued Argentine peso? Possibly, although I suspect that this alternative may be too novel and radical for ready acceptance by the global financial community. However, there are powerful institutional reasons for the IMF and other global creditors to consider this. One, a freely floating Argentine peso would be an adjustment mechanism for the country, helping it to grow its way back to going-concern status. It would align the incentives of creditors and the country in putting growth (and not debt repayment) at the front of the Argentine policy agenda. It would help to mitigate the pejorative spillover Argentine distress is having on the traded debt of other emerging countries.

[1] “Cavallo’s Crunch,” The Economist, April 28, 2001.

[2] “S&P Downgrades Argentina”, Financial Times, May 9, 2001

[3] “Argentina: Looking for Growth”, Global Economic Forum, Morgan Stanley, May 8, 2001

[4] “Argentina: Looking for Growth”, Global Economic Forum, Morgan Stanley, May 8, 2001

[5] “Argentina: Looking for Growth,” Global Economic Forum, Morgan Stanley, May 8, 2001

[6] O’Grady, Mary A., “Cavallo Is Trying Hard, But Argentina Needs A Ghostbuster,” Wall Street Journal, May 11, 2001

[7] “Argentina: Looking for Growth,” Global Economic Forum, Morgan Stanley, May 8, 2001