Learning from Argentina's default

Last September, Argentina's Kirchner government shocked its creditors when it announced terms for restructuring about $75 billion of defaulted international bonds.

These terms, known as the Dubai terms, offered holders of defaulted bonds a deal worth 25 cents on the dollar. Because the Dubai terms did not address Argentina's growing principal and interest arrears, the real value of the offer was closer to 10 cents on the dollar.

Investors responded with a flurry of legal action against Argentina. At the same time, investors conveniently disassociated Argentina from Brazil. This is surprising because Brazil shares an overwhelming number of Argentina's pre-default political, social and economic characteristics. Argentina's effective debt repudiation has created a tidal wave in the ocean of emerging markets investment risk. Meanwhile, investors are sleeping on the beach.

Argentina's political, social and economic structures are finally beginning to recover after the largest sovereign default in history. President Kirchner has successfully consolidated and stabilized the political and social systems while gross domestic product growth in Argentina expanded last year by almost 9 percent.

Encouragingly, political consolidation and social stabilization are becoming entrenched and will contribute to continued strong economic growth over the next two years.

This is an enormous achievement for a country that was gripped by unprecedented political and social instability between 1999 and 2002, when the cumulative contraction of gross domestic product approached 20 percent.

More compelling than the economic collapse that occurred during this period was the surge of individual poverty, which increased from 27 percent of the population in 1998 to 54 percent of the population in 2002. The political, social and economic disasters that befell Argentina were largely the product of IMF-induced economic policies. By discarding these policies, the Kirchner government has enabled Argentina's stabilization and recovery.

Opinion polls over the past few months have consistently shown that about 80 percent of Argentina's population supports President Kirchner. Fundamental to this very high approval rate, and accompanying political and social stability, are the Kirchner government's unconventional economic policies and antagonistic relations with the IMF and foreign private creditors.

Kirchner's economic policies afford greater state control over economic activity through government investment, social development and increased regulation of public service companies and banks. Many of these policies are anathema to the IMF and the source of increasingly rocky relations between the multilateral lender and Argentina. Further straining relations with the IMF is Argentina's approach to restructuring its defaulted international bonds.

Argentina has essentially given defaulted bond holders a take it or leave it offer. This is disconcerting to the IMF and infuriating to private creditors, increasing pressure on Argentina to improve the Dubai terms.

Speculation has intensified recently that the Kirchner government will significantly improve these terms in order to expedite the completion of a debt-restructuring deal this year, driving prices for Argentina's defaulted bonds to multi-month highs. However, this speculation is unjustified. Argentina's stabilization and recovery remain fragile. An improvement in the Dubai terms risks the return of political and social instability as well as economic weakness.

Investors are imperiously suggesting that Argentina can afford to pay more in an eventual debt restructuring deal with foreign bondholders. These investors would be better served by applying the lessons learned in Argentina to Brazil than disparaging about how unjustly they are being treated by a government that is finally putting the interests of its electorate before that of foreign creditors.

Like pre-default Argentina, Brazil has studiously applied the IMF's economic policies. The result has been weak economic growth, deteriorating social conditions and rapidly increasing public sector debt. Annual average gross domestic product growth in Brazil was 1.6 percent between 1999 and 2003.

Over the same period, unemployment more than doubled to 13 percent and cumulative real average earnings contracted by over 13 percent. The outlook for economic growth is discouraging. Gross domestic product growth is not expected to exceed 1.5 percent this year.

This weak economic performance and tragic deterioration in social conditions are a direct result of the IMF's demand that Brazil keep fiscal and monetary policies tight in return for continued access to multilateral credit.

The primary purpose behind Brazil's tight monetary and fiscal policies has been to ensure that the country's fiscal position is sustainable. The key indicator of fiscal sustainability is, at the minimum; stabilization of the public sector debt stock. In Brazil, the debt stock has not stabilized, rather the ratio of public sector debt to GDP has increased from 68 percent in 1999 to over 90 percent in 2003.

By 2005 the ratio of public sector debt to GDP will easily exceed 100 percent. The IMF policies that are meant to contain and eventually reduce Brazil's public sector debt are the primary factors contributing to its growth. The IMF's policies are undermining Brazil's political, social and economic stability in exactly the manner that they undermined stability in Argentina, prompting the country's default.

The only factor that has, so far, prevented a default in Brazil is the generous availability of IMF credit. Brazil is the IMF's largest debtor, accounting for over 30 percent of total IMF loans outstanding. Turkey and Argentina are the second and third largest IMF debtors. Combined, these three countries account for over 70 percent of total IMF credit outstanding.

In Argentina, political and social instability made continued implementation of the IMF's economic policies impossible. This led to the suspension of IMF credit, which triggered Argentina's default. Exactly the same scenario is developing in Brazil and is gaining fuel from Argentina's success in stabilizing its political, social and economic structures despite its effective debt repudiation and the accompanying reversal of foreign private credit inflows.

Fed by economic weakness and deteriorating social conditions, social instability is increasing in Brazil. This is undermining popular support for President Lula, weakening the coalition government and destabilizing the political system.

Political and social instability will eventually force Lula to loosen monetary and fiscal policies in Brazil in order to boost economic growth. This could lead to the suspension of IMF credit to Brazil, prompting the country to default.

The change in economic policy will definitely shock foreign investors banking on Lula to maintain the policy status quo, resulting in rapid flight from Brazilian assets. Argentina's default is a lesson to investors on how to judge emerging markets investment risk. Investors should not carelessly discard this lesson.