News Column

Larry Elliott: Analysis States must be allowed to go bust

August 1, 2014

Larry Elliott, economics editor

Argentina's second debt default in little more than a decade should never have happened. It has been both entirely predictable and entirely preventable.

The problem is simple. Individuals and corporations have recourse to bankruptcy codes that give them protection from creditors. Sovereign states do not. A plan to remedy this omission was floated by Anne Krueger, then deputy managing director of the International Monetary Fund, in the early 2000s. It was strangled at birth by the US Treasury, spurred on by Wall Street.

In place of a sovereign debt bankruptcy mechanism, the IMF backed collective action clauses (CACs), designed to allow a country to do a deal with the bulk of its creditors that would apply to all bondholders. But CACs have proved to be no panacea. They take an eternity to negotiate and can still be challenged by creditors, as the legal action taken against Argentina shows.

So what happens now? The immediate reaction of the markets to the default was muted, in part because it came as no surprise and in part because there is an assumption that a deal will be cobbled together in the next few days. Given that both sides have dug in their heels so far, it may not be.

Failure to settle matters rapidly will have consequences for Argentina. Although its economy is in a less parlous state than it was at the time of the first default in 2001, growth has slowed to a standstill and inflation is running at double-digit levels. Argentina is still unable to borrow on the global financial markets, so the new default will have no impact there. But the peso is likely to come under downward pressure, making imports more expensive and thus pushing up inflation. The poorest and the weakest will suffer most.

There are wider implications. If the so-called "vulture funds" that have brought the current action emerge victorious, it will not only encourage legal action in other cases where creditors have been forced to take a "haircut", but will make future debt restructurings more difficult to organise.

The danger here is all too easy to see. Many countries are saddled with big budget deficits. In the event of another financial crisis - something that seems all too likely - there would be a wave of sovereign debt defaults.

Is the international community prepared for this? Clearly not. The imperative, therefore, is for the IMF to draw up a new blueprint for a sovereign debt mechanism and for the US to announce that it fully supports such a scheme.

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Source: Guardian (UK)

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