Investors have followed the latest twist in the saga of Argentina's sovereign debt pretty calmly. Soon, they may have second thoughts.
In effect, the U.S. Supreme Court has just rewritten the rules of sovereign borrowing -- and not in a good way. It did this indirectly, by refusing to intervene in the legal fight between Argentina and an unusually persistent creditor. The immediate implications may be confined to Argentina, whose outlaw tendencies have made it a special case. The longer-term implications go wider.
Here's the short version of a long and tangled tale: More than 10 years ago, Argentina defaulted on its debts. Later, in two phases, it swapped new bonds for old, imposing losses on most of its creditors. But some of the defaulted securities weren't exchanged. A shifting group of holders led by NML Capital Ltd. has been chasing Argentina through the courts ever since.
In 2012, NML had a huge win. A U.S. appeals court told Argentina not only to pay NML in full but also that it couldn't pay new bondholders in the meantime. Crucially, it also ruled that third parties -- financial intermediaries standing between the debtor and its bondholders -- would face sanctions if they helped Argentina to ignore the rulings. In declining to take the case, the Supreme Court affirmed these judgments.
Argentina -- persistently uncooperative and undeserving of sympathy -- is left with no good choices. President Cristina Fernandez de Kirchner has promised to defy the U.S. court's instructions. That could mean defaulting on all the bonds, old and new alike, worsening Argentina's economic and financial isolation. The smart thing would be to accept defeat and strike a deal with the "vultures," as she calls the holdouts, but this would be a humiliating climb-down.
For everybody else, the issue is longer-term. The underlying problem is that countries can't go bankrupt -- not in a legally recognized way. When they find themselves unable to pay their debts, a court can't step in to allocate losses fairly among the creditors and give the country a fresh start.
Instead, an awkward bankruptcy-like process has evolved through a combination of ad hoc understandings, messy debt restructurings and the principle of sovereign immunity -- that is, the idea that creditors have no good legal recourse against defaulting governments. By appointing financial intermediaries as unwilling enforcement agents, the U.S. courts have undermined this ramshackle nonsystem.
Why, you may ask, is it wrong to give creditors legal recourse against sovereign defaulters? In a properly coordinated process such as bankruptcy, it wouldn't be. Without such a process, though, you've got problems: The next time a government is overwhelmed by its debts, creditors will be reluctant to take part in a restructuring because holdouts will see better prospects of success at others' expense. A disorderly default -- the worst outcome for everybody -- becomes more likely.
There's another complication as well: U.S. law now stands at odds with other legal codes. That will create further anomalies and additional uncertainty.
Granted, financial markets are adaptable. In fact, they began adjusting a while back. New bond contracts typically include collective-action clauses, which make it easier to gather all the creditors together. To make these clauses as effective as possible, though, contract reform will need to go further. In addition, intermediaries will try to build protection against the new risk of litigation into their own contracts. How far they'll succeed is hard to say, and in the meantime, the old agreements are still in place. The point is, the transition to a new ramshackle nonsystem could get bumpy.
Ten years ago, governments talked about creating the treaty-based Sovereign-Debt Resolution Mechanism. That's the right answer, but the idea went nowhere. There's no sign yet that Argentina's debacle is reviving interest. Sadly, it will take more than the plight of a government that had it coming to force action.
--Editors: Clive Crook, Mary Duenwald.