Argentina is facing a debt crisis. In the recent past it has attempted to avoid disaster by a series of fiscal and liability management measures, including a tax increase and a large IMF-led rescue package. These measures only postponed the crisis and that postponement runs the risk of significantly increasing the eventual damage to Argentina and to other countries. Outside Argentina, the uncertainty that surrounds the resolution of the Argentine debt problem has seriously impaired the ability of other Latin economies to raise external financing and will continue to do so for the foreseeable future. Postponement especially threatens Brazil; investors are concerned about the possible "one-two" punch of an Argentine debt collapse and a Brazilian financial crisis, a possibility that is increased by postponing Argentine debt resolution until next year, when Brazil faces what promises to be a hotly-contested Brazilian presidential election. Domestically, the IMF rescue package has increased the exposure of the local financial system to a future default. These factors make urgent the need for an immediate resolution of the Argentine crisis so as to minimize the impact of a spillover.

This paper makes four essential points: (1) an Argentine sovereign debt write down is a long-run necessity, (2) the timing is right for default and restructuring – that is, given current market prices, the identities of debt holders, and the way debt holders finance their holdings of Argentine debt, the systemic consequences of a write down within and outside Argentina are likely to be small now; the consequences could be larger a year from now, (3) debt restructuring could be achieved quickly – in a matter of a few months, and (4) a credible reform package that includes expenditure cuts, trade liberalization, and debt write downs will restart the process of long-run growth, and resolve the long-run uncertainty about the timing and extent of the debt write down; a successful debt restructuring will promote liquidity and new financing in emerging financial markets generally.

The current level of Argentine sovereign debt ($123.7 billion) is not sustainable. The binding constraint on sustainability is the ratio of exports to debt service costs. No reasonable estimates of Argentine export and import growth can produce the net long-run foreign currency earnings needed to service Argentine debt, even if Argentine interest rates were to fall back to pre-crisis levels.

Argentine deficits expanded over the past five years. At the same time, the currency has become overvalued, trade liberalization has stalled, and exports remain a small share of the economy. The economy has not grown for nearly three years. Increased tax rates (rather than necessary expenditure cuts) imposed two years ago as part of the IMF program to reduce government debt growth, have been a drag on the economy.

Last year’s IMF-sponsored debt restructuring failed because it involved no "private sector participation" in loss. Debt holders were told that they would be repaid in full (through assistance from the multilaterals), and were then invited to participate on a voluntary basis, and at market prices, in new debt offerings. This is "private sector participation" in name only, and should not be seen as a bona fide restructuring. A different approach is needed.

A successful policy to resolve the debt crisis would combine three primary elements: trade liberalization (to boost exports), government expenditure cuts and reforms (e.g., drastically reducing co-participation costs and transforming co-participation into a block grant system), and debt write downs. Trade reform should focus on across the board reductions in tariffs (in contrast to the approach recently advocated by Mr. Cavallo, which combines export subsidies and tariff reductions for capital goods with tariff increases for consumer goods). The rapid completion of the FTAA clearly would be an important helpful step. An across-the-board write down of all private sector debts in the form of a reduction in face value of 25-30%, especially if linked to trade and expenditure reform, would result in a credibly sustainable debt burden for Argentina. The details of how best to structure that write down are discussed further below.

The three policies would work together, both economically and politically. Economically, investor confidence in the economy (and therefore, foreign direct investment and other forms of capital inflow) would respond positively to fiscal and trade reform, and that effect would be much larger if the debt overhang were resolved (witness the history of capital inflows in Latin America before and after the implementation of the Brady plan). Politically, a three-pronged approach would credibly "share the pain" of reform, and thus make sacrifices more palatable to all parties (domestic constituencies and foreign creditors).

Alongside these policies, the government must redouble its commitment to the currency board. A devaluation at this time would produce a "debt-deflation" financial disaster for corporations, individuals and banks, given that Argentina is a heavily dollarized economy. It is crucial that the government learn from Indonesia’s experience that a devaluation in a financially dollarized economy does not produce economic recovery. The present government could dollarize as part of its program to restore confidence, but at the very least it should make it clear that it has no intention of switching from a dollar currency standard to a standard based on a basket of currencies (as was suggested at one point by Mr. Cavallo).

The government should refrain from reneging on the operating contracts it signed as part of recent privatizations. While a properly structured debt write down would lead to increased capital accumulation, FDI, and growth, reneging on the operating contracts would have the opposite effect. In the case of debt write downs, capital markets will forgive an inevitable restructuring (witness the enormous capital inflows in the 1990s in the wake of the Brady restructurings), but unwarranted abrogation of operating contracts would substantially damage the investment climate.

The role of the multilaterals in resolving the crisis has two potential components: First, the IMF, IDB, and World Bank might share part of the burden of the restructuring alongside private creditors (discussed in more detail below). Second, the IMF should provide a large line of credit to be used only in support of the maintenance of the currency board.

Consequences of a Debt Write Down for International Investors and Argentine Banks

An analysis of the distribution of the current Argentine sovereign debt indicates that, in contrast to the Asian and Russian crises, the consequences of an Argentine write down of 25-30% of the face value of its sovereign debt to the private sector would not be very dire for international investors (including U.S. institutions) or for Argentine banks. The spillover effects on other emerging markets would not be very large, as there would be little selling pressure produced by the debt write downs.

The anticipation of the problem has already produced significant diversification by international institutional investors (particularly in the U.S). Argentina’s declining debt rating has helped to limit the current exposure of pensions and mutual funds. By all accounts, U.S. pension and mutual funds are substantially underweight in Argentine debt (maintaining a typical weight of 10-15% on Argentine debt relative to other emerging market issues, compared to the 20-25% weight Argentina has in the market indexes). Hedge funds and proprietary desks of U.S. banks are holding some Argentine debt, but those positions are not heavily leveraged, partly because the possibility of an Argentine default has been anticipated since May of last year.

The amount of sell-off by international institutional investors in the wake of a default is likely to be small. In the case of Ecuador’s much larger debt write down, investors held on after the default, as there was little advantage to selling at that time. There is no legal impediment to U.S. pension and mutual funds retaining Argentine debt after default occurs. They would be permitted to hold debts after default so long as it can be shown that it is "reasonable" to do so, given the adverse terms available for selling the debt in the wake of default.

The present timing is optimal for a write down. Prices are already low, so a write down of 25-30% would cause only a small reduction in the market value of Argentine debts (roughly 10-15%). Furthermore, the timing is right when one considers the ramifications of the write down in Brazil. Market participants are concerned about growing debt problems in Brazil, which are likely to become more of a concern in the market over the next year. The immediate exposure of Brazil to contagion from Argentina is relatively small now; Brazilian investors have no significant direct exposures, and there is not likely to be a large contagion effect, given that sell-offs of emerging market debts are not likely to be large as a consequence of the Argentine default. But postponing the Argentine debt resolution for another year will produce much more risk of substantial spillover effects in Brazil than would an immediate Argentine debt write down, given the upcoming election year.

The exposure of European investors is also fairly small. Roughly $24 billion of the $84 billion in outstanding sovereign bonds are denominated in euros. Total European holdings are probably a bit more than that, but as in the U.S., those holdings are spread out and not financed by highly leveraged positions. Spanish bank exposure in Argentina, as elsewhere in Latin America, is related to losses in the local banking system more than to losses on sovereign debt holdings. Spanish banks have recently devoted substantial capital to their Latin American banks (which are separately chartered entities), and thus the consequences for Spanish banks of losses in Argentina are not likely to be large.

A market value decline of 10-15% in Argentine government bonds would not lead to insolvency of the Argentine banks. Market estimates suggest that roughly $30 billion of Argentine sovereign bonds are held by Argentine institutions (banks and pensions). Four large private banks (Rio-Santander, Frances-BBV, HSBC, and Galicia, which together account for nearly half of the Argentine banking system) have total government debt of $12 billion (in market value), and total equity of $4.1 billion. Galicia (the only domestically owned bank of the four) has an estimated government debt exposure of $3.6 billion (in market value) and total equity of $1.3 billion. Thus, a 10-15% decline in market value of debt would not produce bank insolvency. Furthermore, since a large part of the banking system is foreign owned, foreign banks will be able to draw on parent companies abroad as a source of strength to replenish lost capital.

Despite these facts, as a precautionary measure, the government might consider policy options to insulate banks from the effects of a government write down (e.g., a subsidized preferred stock purchase program could be designed to compensate banks for losses on government debt write downs, and thereby avoid the risk of runs on banks caused by fears about those losses). This is a topic worth exploring in more detail.

How To Restructure the Debt

A "good" debt restructuring displays the following six attributes:

1. A speedy resolution of negotiations.

2. A credible long-term result and a widespread market perception that no further write downs will be necessary.

3. A revised cash flow structure that backloads coupons as much as possible to relieve immediate debt servicing cost pressure.

4. The use of inducements (positive and negative) that encourage participation by virtually all creditors.

5. Minimization of the negative spillover effects of the write down on Argentine and international institutions, and on Argentine corporate borrowers.

6. Simplicity of the plan, which is useful for making the plan understandable and for fostering a perception of fairness among creditors.

Exit Consents. With respect to negative inducements for creditors, exit consents are the primary device for gaining bondholder acquiescence. Although the terms of payment require unanimity, the other aspects of the debts can be changed by a simple majority of creditors. This creates a powerful antidote to holdout problems, as was evident in the Ecuadoran case, and can produce a speedy resolution of debt workout in the Argentine case. For example, an exit consent that would limit trading in the preexisting debt without the permission of the borrower would go a long way to encourage participation in restructuring.

Warrants and Bonuses. With respect to positive inducements, attaching warrants on future debt offerings to restructured debts, or the use of a "bonus fund," can provide an "equity kicker" of sorts that makes investors see an advantage from cooperating in the plan to restore economic growth. The use of positive inducements also permits a reduction in debt service costs, which enhances the long-run credibility of the debt restructuring, and permits greater back loading of debt servicing costs. These sorts of devices mimic the standard private debt restructuring device of granting an equity stake to creditors who participate in the restructuring. U.S. pensions and mutuals are permitted to hold such upside inducements so long as they are attached to the restructured debts.

Across the Board Write Downs. To achieve simplicity and a perception of fairness, across the board write downs are best. There are several potential ways to proceed; for example, one could either write down debt face values by the same percentage irrespective of the instrument, or write down debts in proportion to their relative present values per dollar of face value prior to the default. While there are reasonable arguments for proceeding in either way, the simplest and most attractive way to proceed is probably to write down all debts by the same face value discount of 25-30%. Brady bonds and international bonds should be treated similarly. In the case of Brady’s, however, their write downs should be computed after netting out their U.S. Treasury collateral (since the collateralized portion of the debt was not at risk prior to the default).

Creditor Consultation. In the 1980s, the establishment of formal creditors committees, and the protracted negotiations those committees entailed, reflected the realities of that time – that is, the concentration of debt in the hands of a homogeneous group of bank lenders. This approach is neither desirable nor necessary for renegotiating Argentine debt today, most of which is in the form of bonds, which are widely held. To ensure a rapid resolution of debt restructuring, a small consulting committee of creditors should be formed to advise the Argentine government (as opposed to appointing a formal creditors committee to negotiate with Argentina). If Argentina uses a combination of positive and negative inducements to encourage creditor cooperation, it is likely that the debts can be renegotiated in 3-6 months. That forecast reflects two favorable facts: First, Argentina has already assembled many of the necessary documents as part of its recent IMF "rescue" package. Second, the precedents set by Ecuador will hasten renegotiation.

New Private Money? Argentina is currently running a trade surplus. Thus there is little immediate need for new money as part of the debt renegotiation. Restoring investor confidence in the future will restore capital inflows, especially FDI, and there is no need to require new private money as a quid pro quo for restructuring.

Multilateral Participation. Roughly 20% of existing sovereign debt is held by multilaterals and foreign governments. There is resentment in some quarters over the role the IMF, the IDB, and the World Bank played over the past four years in dismissing arguments about the unsustainability of the debt burden, and thus encouraging private capital inflows to finance the burgeoning Argentine government debt. It would add to the perception of fairness if the multilateral creditors bore some of the pain of the restructuring. But it would be very difficult institutionally for the multilaterals to write down Argentine debt (Argentina does not qualify as a HIPC debtor). It would be possible for the multilaterals to bear their share of the cost of restructuring by agreeing to provide increased subsidized credit to Argentina. For example, if the IDB, the IMF and the World Bank lent an additional $20 billion to Argentina in the form of 10 year loans at 7% interest, then in present value the subsidy from the new multilateral loans would constitute a substantial effective contribution to debt restructuring. But an additional $20 billion in long-term loans would lead to a very large amount of multilateral lending to Argentina, and it would perpetuate the counterproductive involvement of the multilaterals in Argentina. Thus, I would not recommend an expansion of multilateral credit as part of the workout package.

In addition to any multilateral burden sharing, if the government maintains a credible commitment to the currency board, then the IMF should offer liquidity support to ensure the maintenance of the currency board (e.g., through the CCL, at a bona fide penalty rate). That kind of assistance would reflect the proper role of the IMF in providing liquidity support to avoid the collapse of a credible exchange rate commitment.

A restructuring along these lines would lead to a speedy resolution of the debt problem. The low current price of Argentine debt will help speed agreement. The 25-30% face value write down would result in some10-15% decline in the market value of debts (since the default risk on Argentine debt would be reduced after the write down). That level of loss would be manageable for investors. The low current price, the use of positive and negative inducements, and the reduced risk of default, would make this package attractive to creditors. It would improve market liquidity and allow the resumption of Argentine access to FDI. If combined with trade and fiscal reform, it would spur expansion of the Argentine economy and its moribund external sector. This restructuring could be achieved with limited risks to the Argentine financial sector, to U.S. institutions, or to global markets for emerging countries’ debts.

Any attempt to bail out Argentine through expanded multilateral lending or U.S. government assistance would amount to a failure to seize the opportunity to deal with the debt problem now, before it gets worse and before it further stalls Argentine economic growth. Furthermore, a bail out by the Bush Administration at this juncture would make any future restructuring all the more difficult. Low market prices today make a write down easier, and those low market prices reflect the realistic expectation by creditors of default. A bail out by the new U.S. Administration would boost prices today and in the future, and result in greater creditor resistance to a future write down.

In summary, the sooner the workout is begun the better.

* I thank several market participants, who prefer to remain anonymous, for helpful comments on an earlier draft.

Charles W. Calomiris is a visiting scholar at AEI.