ECONOMYNEXT – Debt restructuring can be a painful exercise fraught with risks to politicians but delays and actual default can lead to worse outcomes, Lee Buchheit, an international expert involved in repeated Latin America defaults and a Greek debt crisis, said in a Sri Lanka forum.
Debt re-structuring requires extensive negotiation with a range of private and official creditors, needing a commitment to domestic budget cuts to balance losses imposed on bond holders and creditors, and make it possible to repay later debt, Buchheit, a legal expert who had mostly worked for debtor nations said.
A re-structuring deal can be worked out in as short a period as one year, but can drag on for years if no agreement is reached which can worsen the economic fallout, Buchheit, told an online forum organized by Echelon, a Colombo-based financial magazine.
Politicians typically dislike debt restructuring as they involved tax hikes spending reform, and try to delay them hoping something will happen to change the trajectory, he said.
Buchheit is a 40 year veteran at Cleary Gottlieb Steen & Hamilton, a US-based law firm, who retired in 2019, and has served as Adjunct Professor or visiting lecturer including at law schools of Columbia, Harvard and Yale.
Buchheit first began working on Latin America defaults in the early 1980s, when the US Federal Reserve raised rates and Latin American soft-pegged exchange rates began to collapse. In the summer of 1982 Mexico had said it needed a moratorium on its external debt payments.
Fed Hikes and Prebisch-Triffin Banks
Many Latin American nations had borrowed from mainly US banks in 1970s on floating rates, Buchheit said.
The US dollar collapsed against gold in 1971 due to output gap targeting (Keynesian stimulus) by then Fed Chief Arthur burns. The collapsing US dollar fired bubbles in energy, food, base and precious metals contributing to a boom in commodity exporters, including Latin America.
As a result, in the 1970s US banks were flushed with so-called ‘Petro dollars’ re-invested by Gulf Corporation Council oil exporters, which had stable currency-board-like British designed pegs which could not sterilize the balance of payments for counter-cyclical policy.
“At the end of the 1970s, the then chairman of the Federal Reserve Paul Volcker in an effort to deal with inflation in the United States raised US interest rates very high to the point that by 1981 Libor got to be 22 percent per annum,” Buchheit said.
“Mexico was the first that my former law firm represented. As 1982 and 1983 went on, some two dozen countries went through the same process.”
Argentina sought International Monetary Fund support in 1983 as it was also hit by forex trouble.
The IMF typically asked central banks to raise rates to limit money printing, float to make reserve money inconvertible and makes sure the agency is kept to a monetary program.
Taxes are also raised to reduce the budget deficit or expand a surplus to keep the corrective interest rate down. Rates tend to shoot up as confidence is lost in the currency and domestic bonds.
Buchheit says foreign lenders usually prefer to have an IMF program as they themselves lack knowledge of economic problems and also have no capacity to make the necessary adjustments.
If the currency collapse is very steep, however there is a sharp output and consumption collapse, governments change and IMF programs are then jettisoned, analysts say.
Argentina was the original Latin American counter cyclical central bank set up under Keynesian principles by its founder Raul Prebisch in 1935. Prebisch later worked at the Mexico central bank after he was fired by President Juan Perón.
Prebisch, along with US Fed’s Latin America chief Robert Triffin and his ‘money doctors’ set up disastrous counter-cyclical sterilizing central banks across Latin America with swiftly collapsing pegs.
Constitutions of some stable gold standard central banks set up in the 1920s were also tinkered to be able to print money, and finance government programs in the 1930s and 1940s as Keynesianism spread like a new religion. Almost all swiftly went off the gold standard.
Counter-cyclical Latin American central banks which were pegged to the US did not raise rates in tandem with the Fed, unlike the GCC and East Asian ones, and tried to continue a boom fired when US rates were low, triggering currency collapses regardless of whether the fiscal situation was good or bad.
Poster Child
Argentina is the poster child for currency collapse and external default. The central bank regularly strikes zeroes off the currency.
As the soft-peg shattered in 1983 a new Peso Argentino was introduced at the rate of 1 for every 10,000 old units. A bailout worked for a time as US interest also fell.
In 1985, a new currency, Austral was created replacing one for 1,000 Argentino peso, as Volcker raised policy rates to 11 percent in the next credit cycle.
In 1986 Argentina defaulted again.
Argentina and many Latin American countries had been borrowing abroad for almost two centuries and had generally open capital accounts.
However with the setting up of Triffin Prebisch central banks, forex controls, parallel exchange rates, high inflation and social unrest proliferated. Import substitution was pioneered in the area.
Argentina first defaulted in 1827, soon after Bank of England started to raise rates in 1825 to slow credit and stop a balance of payments deficit (run on gold reserves). The Bank of England had just restored gold convertibility in 1821.
Gold standard central banks do not print money (sterilize interventions) against the BOP but raises rates like currency boards, when domestic credit picks and there are gold outflows.
Latin American central banks sell dollars to defend a peg and then sterilize the interventions to maintain the policy rates through the purchase of domestic securities injecting more money (sterilized forex sales) until reserves run out, and then devalue sharply.
The IMF usually supports devaluation, hoping that it will boost exports, but repeated devaluations in Latin America had failed to boost exports and exchange controls discouraged foreign investment.
Instead, social unrest, out migration and resort to prostitution by sections of the female workforce to buy food was the usual outcome of Keynesian stimulus and devaluation.
Export powerhouses including Japan, Germany, Singapore, Hong Kong and Taiwan did the exact opposite monetary policy.
Analysts say the archetypal ‘Latin America clause’ was put in to Sri Lanka’s Monetary Law through its section 90 (1) which enable the agency to create currency crises even without deficit spending or direct government finance by the central bank.
Related
In the 1980s as Sri Lanka’s rupee also devalued or was pre-emptively depreciated in Latin America style ‘tablito’ moves without commercial debt to defautl, triggering high inflation, social unrest and migration to GCC countries with stable pegs was seen.
Bond Defaults
In the 1990s bonds replaced banks loans to Latin America.
“In the 1990s commercial banks left the process and were replaced by bond holders,” Buchheit said. “In this century the sovereign debt crises to the extent they involved commercial lenders have almost all been bond re-structuring.”
In 1994, the US Fed started to raise rates. Mexico had fixed its budgets but had failed to seriously reform its central bank.
Instead of raising rates Mexico issued tesobonos dollar debt.
Amid some domestic political turmoil Mexico central bank went into a into a currency crisis as outflows were sterilized and the credibility of the peg was lost. In December 1994 the Mexican pesos devalued as the Fed continued to raise rates.
Mexico had an overall budget surplus of 1.6 percent of GDP in 1992, 0.7 percent in 1993 and had a balanced budget in 1994.
The primary surplus was 3.9 percent of GDP in 1993 and 2.6 percent in 1994. An IMF program was designed with a 5.0 percent of surplus budget and 3.4 percent primary surplus for 1995.
In 2017 the Fed started to raise rates and continued to raise rates through 2018. Argentina went into a currency crisis 2018. Sri Lanka also cut rates and injected liquidity and went to a crisis.
Greece went into a debt crisis after the Bernanke-Greenspan bubble burst following Fed rate hikes up to 2007.
Greece however had serious budget problems like Sri Lanka mainly involving civil service salaries and pensions.
Greece defaulted on what was essentially local currency debt as it was in a monetary union and the ECB would not usually finance the government directly.
However the ECB bought bonds as part of the bailout package.
A debt restructuring may involve term extensions to the principle (debt-reprofiling) were new longer term bonds are issued, or reductions to the principle (hair cuts) or rates (coupons).
“The legal aspect is relatively small,” Buchheit said. “There is an enormous political aspect to it both internationally and domestically in the debtor country and in all candor, a great deal of theatre.”
Analysts say the theatrics rise dramatically when civil service is involved with the anti state-austerity brigade firing on all cylinders.
It was exemplified by Greece, whose politicians were unwilling to cut salaries.
Euro area countries which were bailing out Greece pointed out that their civil services did not get the benefits that Greek had even after budget cuts.
In Sri Lanka under IMF led ‘revenue based fiscal consolidation’ civil service salaries and pensions were ratcheted up with taxes raised to a ‘magic number’ revenue to GDP ratio.
The program involving ‘flexible’ inflation targeting, triggering currency crises forcing debt to be repaid with more debt like Mexico’s tesobonos rather than current inflows appropriated through higher rates.
Sri Lanka’s policy errors were radically worsened by Keynesian fiscal and monetary stimulus from December 2019.
In a devaluation salaries are cut automatically of both state workers, private workers and the real savings of savers especially the aged and the weak.
But if the currency does not devalue it is impossible for a government and Keynesians to inflict pain on private wage earners and bank savings accounts through depreciation forcing budget cuts. (Colombo/Oct06/2021)