The recent news of Argentina’s deal with holdout hedge funds has prompted me to put together a three-part series on Emerging Markets, and analyze this crises struck asset class. Enjoy!
In the 70s, international organization such as the International Monetary Fund (IMF), World Bank (WM), International Development Banks (IDB), and other bilateral or multilateral development organization began lending money to third world countries in order to develop infrastructure projects, and thus began the Sovereign Debt Market for developing economies. Of course, sovereign debt didn’t quite start in the 70s; war bonds were issued by countries like Britain and the US to finance conflicts in their own soils or abroad, as well as allowing Britain, France, Portugal, and Spain to finance purchases of new territories during the colonial expansions of the XVI to XIX centuries. But the sovereign debt market brought with it a new type of investment: local market risk on hard currency. In one swift motion, the sovereign debt market had disposed of the foreign exchange risk while keeping the regional risk on the books. This worked fine until it stopped working
By the time most military dictatorships that spun from the 70s up to the mid-80s came to an end, and a new era of democracy was taking over, countries began to realize that certain debts couldn’t be afforded without severely disrupting to the economy and the locals’ way of life. It was then, that a seemingly smart investment – the hard currency sovereign debt began under performing its somehow less fashionable cousin the local currency debt.
The scenario was simple: there was a premium for investing in local currency, sometimes up to 50 percentage points more than investing in US Dollars, for seemingly the same risk, but this was obviously taking into account potential devaluations caused by inflation or in some cases hyperinflation, which drove some countries to change currencies several times. The table below shows the currency changes in some South American countries during the 80s and early 90s.
One unit of Argentina’s currency in 1992, the Peso Convertible was the equivalent of 10,000,000,000,000 (ten trillion) 1970’s currency; there was a devaluation in 1970 where the Peso Nueva Moneda – not shown in the table – was re-denominated as Peso at a rate of 100 to 1. In Brazil, 1994 currency was the equivalent of 2,750,000,000,000 (two and three quarters trillion) of its 1986 currency. Peru had it relatively easy by dropping “only” 1 billion times the value of its currency.
This meant that investments in locally denominated currency debt, were at great risk of having their value wiped off in little or no time; however, because they were in local currency, and the governments could print as much of it as they wished, they were by general rule almost always honored. By contrast, sovereign debt issued in hard currency, which provided the investors with an added level of safety by not having the F/X risk were to a great degree subjected to defaults.
A World Bank paper titled “Commercial Debt Restructuring” cites that in the 1980 to 2000 period, multilateral debt relief agreements with commercial banks exceeded US$565 billion including deferment and rescheduling of current and defaulted debt.
During the mid and late 70s, widely available petrodollars were recycled back into the emerging markets in the form of relatively cheap syndicate loans made by commercial banks. These loans were directed mostly towards infrastructure projects such as roads, dams, airports, etc. Relatively low interest rates, soaring commodity prices, and the introduction of the Eurobond market, made it easy for emerging Latin America to borrow, resulting in a massive expansion of sovereign debt.
As the inflation of the 70s became the recession of the 80s, Paul Volcker, the then chairman of the Fed started raising rates to control the domestic inflation. Rates for treasury bonds reached a nose-bleeding 20%. While the interest rate hike helped the US reignite its economy, it had serious effects on Latin America. Higher interest rates meant debt service repayments for indebted countries would rise dramatically, and a global recession meant lower demand for their products.
Meanwhile at home, Latin American countries who had indebted themselves by up to 50% of their GDP, were facing deficits in their trade balances due to increasing oil prices in the late 70s stagnating their economies. To overcome the outflow of capitals, governments started keeping official exchange rates at fictitious heights. During the 80s official exchange rates were introduced In Latin America, where the central banks would control the amount of dollars in the market, they would have an exchange rate for exporters, and a different exchange rate for importers; furthermore, the central banks would impose quotas in order to control the amount of dollars that left the country. This led to the creation and expansion of a dollar black market, where people would buy and sell the hard currency at a free market prices. To deal with this, and in order to make the local markets competitive enough, the interest rates would have to be a lot higher than those at countries with hard currencies – remember that countries with hard currencies had rates of around 18%. This led to two phenomena:
Many foreign investors would borrow dollars at a lower interest rate, buy local currency, invest at a higher rate, but because there was a regulated market, announcements would be made of when devaluations would take place, and as soon as one was on the radar, they would sell their positions and take the money away. This would put pressure on the market, reducing the amount of floating dollars, and increasing demand by the public on the black market. By the time the new official exchange rate was set it would be a lot lower than expected, accelerating the devaluation process in the black market. Locals would purchase dollars every pay-day in order to preserve their purchasing power, thus creating an increased demand for a shrinking supply of dollars. Exporters on the other hand would feel short-changed by being forced to sell their dollars at the lower official rate, and so started the double booking, where many exporters would declare only 10 or 15% of their total exports, therefore keeping a large percentage of their dollars to be exchanged in the black market at a much higher rate. This would reduce the international monetary reserves of the country and force the governments to devaluate even more the currency to make up for the shortfall.
Higher dollar prices meant that all imported products or local products using foreign raw materials would increase in price; at the same time, the government would increase rates in local currency to promote investments. The vicious circle begins… higher rates attract foreign investors, they buy local currency, invest at high rates, then buy the dollars in the black market pushing its price higher, local public starts buying dollars, to preserve their purchasing power, since prices are going up, this drives exporters to hold on to their dollars and not sell them on the official channels, driving international monetary reserves lower, and forcing the governments to devalue the official exchange rate. Several months of this behavior would trigger a feeding frenzy that would inevitably lead to hyperinflation, and mega devaluations.
In 1982 exiting President Jose Lopez Portillo y Pacheco announces the nationalization of the banking sector, and a subsequent default on the sovereign debt. This kick-started what became to be known as the first contagion effect of emerging markets. At the time there was little or no differentiation between economies. Emerging markets were emerging markets, and they all got lumped together, especially if you were part of the same continent or sub-region. Argentina whose own internal problems started a year earlier and Brazil were the first ones to suffer as a consequence of Mexico’s default. Within a year the crisis had expanded to Bolivia, Ecuador, Chile, Costa Rica, Honduras, Jamaica, Nicaragua, Peru, and Uruguay in Latin America, and directly affected Yugoslavia, Turkey, Nigeria and Morocco.
The Mexican Peso devaluated 245% between 1981 and the days leading to the default. The trend would continue inexorably until the currency was re-denominated from Mexican Peso to Mexican Nuevo Peso in 1993.
Argentina had problems of its own. As in most of South America, junta governments were in fashion. Reynaldo Bignone was the last of the de-facto leaders in the Gaucho nation; in fact he had convened elections in 1984, however the crisis that struck Argentina in the early 80s forced him to hold them earlier. Enter Raul Alfonsin, the first president of the new democratic era in Argentina, who ruled during most of the 80s, in what was later to be remembered as the “lost decade”. He oversaw 2 different currency re-denominations, 2 debt restructurings, and a debt default. The deplorable economic environment and civil unrest forced him to leave office ahead of time, and be replaced by Carlos Menem.
In 1985 Treasury Secretary James Baker identified 15 countries with relative healthy economies and large sums of debt. The plan involved lending an additional US$ 20 billion, and restructure the terms of the outstanding debt, breaking it up in tranches, capitalizing past due interest and extending the maturities; the use of multilateral organizations such as the IMF and World Bank to provide new loans; and for the governments of indebted nations to adopt market-oriented approaches such as trade liberalization policies, privatization, reduction of trade barriers, and taxes, investment liberalization and floating exchange rates to promote economic growth. The plan was ultimately unsuccessful due to lack of consensus.
Other Devaluations and Debt Restructuring of the 80s
As the economy suffered, military juntas across South America were paying the ultimate price. Elections were taking place, and towards the early 80s there was a new widespread return to democracy. Given the erosions in the economy, the new governments were left with hard choices to make, and tough decisions to take. This involved in most cases either an outright devaluation to make their exports more competitive, and restart the economy, or they were simply playing catch-up with the black market that had long before determined the real market value of the US currency. In any event, these devaluations took place in several countries at almost the same time. Brazil had a major currency devaluation in 1986 followed by another one in 1989. Peru had its first mega devaluation in 1985 (around the time that the Baker plan failed to take off).
Up until the introduction of the Brady plan in 1989, 11 Latin American countries had suffered 26 debt restructuring events, including defaults. Most events involved refinancing, debt moratoria, extending maturities, grace periods, interest only tranches, etc. The result increasing debt and no certain way of paying it back. Towards the end of the 80s, total outstanding debt was approaching US$ 315 billion, and the economies were taking a nosedive.
As Secretary of the Treasury under George H.W. Bush, Nicholas Brady went one step further than his predecessor devising a plan to restructure emerging market debts under a variety of conditions. The new proposal would consolidate all existing sovereign debt and repackage it into different tranches.
The two main types of bonds were Par Bonds, which would retain the original value, while the coupon would be below market rate. Discount Bonds were issued at a discount to the original value of the loan; the coupon, however, was kept at market rate. Both tranches of bonds had as an added feature principal and coupon guaranties.
Other types of bonds included Past-Due Interest (PDI), these would take all the past due interest, and interest on interest accrued over time and capitalize them in one tranche; Interest Equalizer Bonds (IEB), a smaller tranche of bonds issued to equalize the amount of interest lost from the restructuring of pre-Brady debt; and Front-Loaded Interest-Reduction bonds (FLRIB), these would be issued in special circumstances to allow for a smaller principal to be handed to the borrower in exchange for lower overall interest payments throughout the life of the bond.
Unlike the unsuccessful proposed Baker Bonds which suggested the issuance of even more debt to highly indebted nations, the Brady Bonds restructured the debt, and the total amount of face value of bonds issues was less than the pre-program face value, which meant investors suffered important haircuts.
Brady bonds were first adopted by Philippines in August 1989, followed closely by Mexico in September, and Costa Rica in November of the same year. Venezuela and Uruguay restructured in 1990, Nigeria in 1991, and Brazil in 1992. Then the floodgates opened: in a two year span between 1993 and 1995 Bolivia, Bulgaria (who had never before restructured or defaulted on their sovereign debt), Dominican Republic, Ecuador, Jordan, Panama, Peru, and Poland all restructured their outstanding debt through the Brady plan.
Mexico was the first country to retire its Brady bonds in 2003, between then and 2007 Colombia, Brazil, Venezuela, and Philippines followed suit. Ecuador and Russia restructured their Brady bonds several times, and in 1999 Ecuador became the first country to default on the Brady bonds, which would later be structured into Global bonds with only two tranches: the 2012 and the 2030 (both of which would default on in 2008).