STATE BANKRUPTCY

What happens when a state goes bankrupt? For those who are interested, Argentina shows the way.

On 30 July Argentina defaulted on its foreign debt, for the eighth time in its history. The seeds of the latest default stem from the seventh, back in 2001, when it couldn't pay some US$81 billion of foreign debt. Under two restructurings, 93% of the bondholders took a serious "haircut" and accepted new securities, which Argentina has been servicing since then. However, the rest of the debt was scooped up cheaply by investors, often called "vulture funds", some of whom pursued Argentina through the courts for repayment in full, plus interest and costs.

Such a course of action takes time and money, persuasive reasons for the 93% to take a haircut. But for those prepared to stick it out, it can bring big rewards. Earlier this year, a group of the hold-outs won a ruling in a New York court (many international US$ bonds are issued under New York state law) that a contract is a contract, so Argentina should pay full interest and principal. Furthermore, since all of the bonds are similar, it would be illegal to service the new bonds belonging to the majority unless the minority were paid in full. Argentina appealed the ruling to the U.S. Supreme Court; but on 16 June, it decided not to get involved, thereby letting the ruling stand. Because of the injunction, an interest payment on the new bonds was not paid when due on 30 June; one month later, Argentina was in default.

It may seem unfair that a small minority of bondholders can dictate the financial affairs of a whole country. However, Argentina has played its hand incredibly badly. Essentially it has tried to ignore both the vulture funds and the court ruling, instead of negotiating with them and coming to a settlement. The sanctity of contracts is something that most legal systems value highly; pretending otherwise doesn't help at all if you want to continue to have access to the world's financial markets.

But do you? In theory, a country could satisfy all of its borrowing needs from domestic sources. However, the reality is that all countries need some foreign borrowing, since the only alternative means of paying for imports is export revenues, and they are not always available.

Given that, it is probable that a solution will be found in due course. However, by behaving so cack-handedly, it is highly likely that Argentina will have to pay a price in the form of a higher interest rate on its bonds in the future than it would otherwise have had to pay. There's a cost to being stubborn.

Walter Blotscher