United States: Sovereignty Behind Latin American Sovereign Debt

Some of you may remember a scene from the 1984 hit movie Wall Street where at the annual stockholders meeting of a paper manufacturer the Chairman of the board (Richard Dysart) tries to dissuade stockholders from giving up control of the corporation to Gordon Gecko (Michael Douglas): "Your company, ladies and gentlemen, is under siege from Gordon Gecko, Teldar Paper is now leveraged to the hilt like some piss-poor South American country …. I strongly recommend you to reject his tender …." If you take into account that during the so -called "lost decade" of the 80’s most South American countries could have been qualified as piss-poor, this phrase may have upset extremists living in those countries since it made them realize that for some people in the developed world their nations were considered inferior to a world-class, albeit indebted, corporation. In fact, the Spanish and Portuguese subtitled translations were not as emphatic as the chairman of Teldar’s speech was. Today, given the current globalization of business, it may not be considered prudent to use a phrase like that in any stockholders meeting. However, the reality is that very few South American nations have achieved the status of prime borrower before the eyes of banks and rating agencies of developed countries. This circumstance did not prevent some of those countries from continuing to interpret and, to the extent possible, to apply the concept of sovereignty in a very traditional, literal and archaic way. Nor did those nations stop considering sovereignty as a fundamental foundation of their respective political systems during the 80’s and 90’s. Today, nevertheless, we find surprisingly that some Latin American countries understand that the value of the concept of sovereignty is more historical than otherwise, and that its practical applications are few within the economic realities of those nations.

The concept of sovereignty has carried the most contradictory and incompatible of meanings. Nevertheless, most people understand the term as the power of self-government by a state; that is, of independence from all other states as far as its own territory and citizens not living abroad are concerned. This denotation is expressed or implied in most South American Constitutions, depending on the most influential foreign doctrine on which their bodies of laws are based and on the creativity of local legislators. In most Latin American countries sovereignty was for a while always absolute, indivisible, unconveyable and unlimited. If you accepted the term as it was originally conceived, not even time could impose boundaries on this power. Thus, sovereignty was so supreme that it was considered almost divine.

In reality Latin sovereignties are far from divine. Latin sovereignties do fail to comply and perform its international debt obligations and are not considered a prime borrower. Take for instance the case of Argentina, which after receiving assistance to meet its international foreign obligations makes us reconsider the whole subject about sovereign lending. Argentina was on the verge of defaulting its external obligations before requesting multilateral aid. The slowdown of the global economy made the country seek urgent assistance despite being a borrower who had applied most economic measures the IMF recommended. Since the Argentine debt recently relived was originated by the refinancing of a previous debt impossible to pay in the past, would it be possible to say that Latin American sovereign debt is a cycle of debt, default, relief, debt forgiveness, more debt, more default, more relief, etc?

In its December 2000 issue Latin Finance reported that the Latin American sovereign debt had deteriorated precipitously following two credit downgrades from Standard & Poor’s. The March 2001 issue of the same magazine said that earlier this year Latin sovereign borrowers had experienced a dramatic reversal of fortune since investor attitudes had changed inter alia because Multilateral Institutions had bailed out Argentina in December with a US$39.7 billion dollar rescue package. Latin Finance also noted that the loss of investment grade rating of Colombia, the default of Ecuador on its debts 2 years ago and the political scandal in Peru were sufficient to cause the Andean region’s already struggling capital markets to crash, driving away more investors as liquidity dried up. However, the magazine concluded its sovereign funding report by affirming that if the threat of a US recession was averted, or at least mitigated, the Latin borrowing fiesta could continue. Although the current US economy has not improved much since March, the prediction was correct; Argentina, as we mentioned, and Brazil have just negotiated additional credit lines with the International Monetary Fund to be able to meet their financial responsibilities.

When US or Western European analysts from rating agencies and major banks determine that an emerging market country is not following what experts consider sound economic policies, the analysts place the country on a watch list that automatically makes the country’s debt price in the secondary market sink. Other reasons for watch-list status could be that the price of the country’s principal export commodity has declined, or that, with the exception of Argentina, monetary authorities are artificially manipulating the price of the local currency in relation to the US dollar by intervening excessively in the foreign exchange market. The sudden unfavorable impression of the analysts forces the government of the country subject to the downgrade to explain the reasons for its misbehavior. Depending on how affected the country’s debt profile is viewed in the international financial markets, the government might also be forced to change economic policies in a conspicuous manner so the analysts may reconsider their assessment. This reaction is very similar to those of any publicly traded corporations in Europe or the US.

The only difference between sovereign debt analysis and reports made on the outstanding debt of second or third-tier corporate borrowers from the developed world is perhaps that the latter reports would offer a more precise and safe forecast on the outcome of investments in those corporate borrowers. After all, US corporate debt is much more covered by analysts than Latin sovereign debt, which is only a niche of international financial markets.

Yet, some people may argue that the difference between sovereign debtors and corporate debtors is that the rules that apply to the latter do not apply to the former because, as we have seen, historically sovereigns have had rights, which were in essence absolute in nature. Nevertheless, recently many countries, forced by the development of worldwide commerce and globalization, either through implementing regulations, non-appealable court decisions, or by executing international conventions, have adopted the modern restrictive theory of sovereign immunity as it was embraced by the US Department of State after World War II. Said theory briefly maintains that foreign governments are not entitled to absolute immunity for their actions.

Take the example of the Brady Bonds, a type of sovereign bond that is part of a US government debt program that combined US government and multilateral support in obtaining debt and debt-service relief from commercial bank loans for countries who committed to the implementation of comprehensive structural reforms supported by the IMF and the World Bank. When Latin nations signed their respective Brady Bond contracts, sometimes going against their own Constitutional texts, renounced to their sovereign rights under US and English Sovereign Immunity laws, which basically recognized those absolute rights traditionally attributed to sovereignties. Just the fact that Brady bonds are all governed by either New York or English law was an implicit waiver to those absolute rights, or an acceptance that the sovereignty of those debtor states, as with any other developed state of the world, was not as absolute and inalienable as the traditional doctrine conceived. Additionally, when commercial bank loan to sovereign nations were converted into Brady Bonds in the late 80’s and early 90’s the debtor creditor relationship with the sovereignties stopped being bilateral or between the sovereign borrowers and banks from 2 or 3 countries. When this conversion took place, the Brady debt was so widely distributed among investors that what once was considered classified information about a debtor country now could be exposed to a large number of holders. Sovereign debt these days is so widely held that that the pressure over issuers not complying or close not to comply with their respective obligations is global and more effective than any coercion banks alone were able to impose in the past.

When the traditional concept of sovereignty was developed, what states intended to achieve was autonomy and the reaffirmation to their subjects that the state was absolutely independent of any other state or entity. The admission, even if implicit, of any foreign intervention would put the authority of the state in question. The same happened when Latin nations became independent of their conquerors in the early 19th century; their declarations of independence had to emphasize to a large extent the absoluteness of the power of their nations. At the time, no Latin American government was going to admit that they were not absolutely immune for their actions. Times are different now. Very few countries, if any, could claim that they are sovereign to the extent the term was understood when the concept was developed. Still, many Latin American Constitutions continue to express the notion that their nations are completely independent of any other nation and that the power of the sovereignty extends above the law. This has not prevented modern Latin Constitutions from, at least implicitly, favoring integration and subordinating local regulations to international treaties to regulate integration with its neighbor nations.

Why did Latin countries take longer than developed nations to accept that the concept of sovereignty was less applicable than it ever was, and why do some Latin governments still continue to use the definition as a political emblem? In part for the same reasons the signatories of the declaration of independence of those nations did, and also because the concept of sovereignty has had an inestimable historical value for them. The mere affirmation that the nation is sovereign has given Latin countries and also nations in other regions a feeling of their own dignity to the individuals who form those states. One example of this historical value is the downfall of the empire and the almost immediate execution of the Austrian born Mexican Emperor Maximilian on the Hill of the Bells outside of Queretaro in 1867. The execution was intended as a powerful deterrent to European monarchies that might have though to intervene in the affairs of Latin American republics, while representing the survival of Mexico as a sovereign state. The other manifestation of Latin sovereignty that we could mention was the Inconfidência Mineira of 1789 in Ouro preto, Minas Gerais, Brazil. The Inconfidência was a defeated rebel movement that attempted to declare Brazil a republic by defeating the empire reigning at the time. The failure of the Inconfidência and the hanging of its leader Tiradentes, together with the display of his head in Ouro Preto, made people sympathize with the inconfidentes and made Tirandentes a national hero once Brazil became a republic. Incidentally, Mexico denied payment of its foreign obligations after the removal and shooting of Maximilian.

One might think then that empirical evidence suggests that the difference between sovereign and corporate borrowing is that sovereignties have the right to delay and sometimes not to pay their debts. Apart from this, it is harder to enforce payment when nations rather than corporations are involved. The enforcement of Latin sovereign debt often comes in the form of refinancing, or as some analysts call it "a punitive default settlement". The refinancing of sovereign debts can take longer than its equivalent in corporate debts, depending on the commitment that the maverick country is ready to assume in accordance with the refinancing contract and the law that governs that agreement.

Many sovereign bond contracts are the result of the refinancing of a previous defaulted financing or of a financing commitment that was impossible to meet. When a refinancing agreement is drafted, no room for freedom is left. Sovereign debtors that have defaulted cannot do anything but comply with their new contractual debt obligations and enjoy the debt reduction characteristic of this type of refinancing. When refinancing is necessary, in many instances, the refinancing agreement supersedes local economic laws. Today, because the current drafting of international debt agreements contemplates the threat of asset seizure in conjunction with concerted creditors action sovereigns could have considerable incentive (where capacity exists) to settle bondholder claims with the interest of bondholders in mind. Unfortunately, the bond covenants related to sovereign asset seizure have proven unenforceable when the issuer is sovereign. Furthermore, bondholders of sovereign debt have to accept and carefully consider debt forgiveness as an ever-present part of their negotiations with sovereign debtors who have defaulted or are about to default. Take for example Ecuador, the first country to default its Brady Bonds obligations, where more than 45% of debt forgiveness was given to the country, for which after the default it has been very difficult for the Andean nation to raise additional financing in the international capital markets.

During the renegotiation of refinancings, the destiny of the debtor nation’s wealth may well be determined by the dynamics of the secondary-market trading of its distressed sovereign debt, given the potential profit the holders of such debt may realize by selling the defaulted securities. This may influence the demands of the bondholders under the refinancing negotiations and, ultimately, the likelihood of settlement. Bankruptcy, the extreme for corporations and the refinancing of their debt, does not exist in the context of sovereign debt.

What is the difference then between the pre-commitment that managers of corporate firms make when, by assuming large debt obligations, they promise in advance not to retain substantial corporate earnings and the imposition of fundamental economic choices on emerging market debtor nations by their foreign creditors during the refinancing negotiations? The bondholders of corporate debt have legitimate property entitlements in the private firm even if they don’t constitute the residual claimants of the firm’s wealth, something hard to achieve for sovereign creditors.

For US corporate bondholders, the legal system provides powerful protection in the event of default: acceleration and bankruptcy proceedings. Bondholders usually direct the play once the debtor files for bankruptcy. In sovereign defaults it is actually the country that controls the negotiations because there is no international bankruptcy court and the threat of sovereign assets seizure is not strong or credible enough to enforce the relevant judgment. The recent experiences shown by Russia and Ecuador where bondholders chose not to accelerate the bonds are evidences of this. The acceleration process nevertheless would have been lengthy and, for some people, superfluous. Since most sovereign creditors choose not to accelerate based on cross-default provisions because they know that there would be little, if anything, to attach, that leaves the holders of the bonds who chose to accelerate alone before the sovereignty trying collect on judgments. This gives the sovereign, in our view, freedom to default selectively among different holders of its debt. Acceleration is also mitigated because there is market for defaulted bonds. The holders exchange the burden of going through an almost impossible-to-win law suit for a little piece of security by selling the defaulting bonds at deep discount to investors who have the patience and the guts to wait for the next refinancing. The burdens to accelerate payments in case of default are significant enough to make some analysts contests that it is the expected recovery value of the debt that matters more for sovereign bondholders rather than just the likelihood of default, as it is the case with other bonds.

Sovereign debt refinancing is a complicated issue that goes beyond the scope of this note. However, we could summarize our thoughts by saying that when a country needs to refinance its foreign debt it mostly does it for reasons of liquidity and to be able to maintain solvency of its payments. If Argentina, for example, were to refinance its current debt it would probably try to spread out the payments that are extremely concentrated between 2002 and 2009 in order to avoid eventual liquidity crisis. Sovereignties in default look to maintain solvency as an alternative to defaulting, which would undoubtedly make the country subject to trade blockades and universal denial of new credits. Sovereign creditors accept the refinancing alternative because forceful enforcement would practically be impossible, and because the present value of the amount to be recovered at maturity of the refinanced debt or the product of its sale in the secondary market, is potentially higher than the sum that might be gained by undertaking an onerous and almost unrealizable collection process. Although debt refinancing generally implies debt forgiveness and emergency loans so the debtor country is able to maintain solvency, it is apparently the most efficient and equitable solution available.

Why do investors go through all that suffering and bear the risk of frequent defaults instead of limiting their investments to the acquisition of corporate bonds from developed nations? Because, historically at least, sovereign debt, Brady bonds for example, are seen as a good investment. In the last ten years these instruments have provided a higher return than the US high yield bond market and are perceived as more liquid instruments than its corporate peers. In part because some Bradys guarantee principal payments, and in part because bond buyers still perceive sovereignties as a better credit than corporate bonds. However, the difficulties associated with sovereign default and re-negotiation of the respective refinancing have made some analysts argue that sovereign bonds should actually trade at a wider spread than comparably rated corporate obligations.

For Latin nations and debtor nations in general, the value of the concept of sovereignty, at least scientifically, is illusory today. Science wants concepts that are unequivocal and without diverse connotations. This is not the case of sovereignty. Governments these days have to understand that even if they called themselves sovereignties in the most traditional sense, a country that cannot independently provide for its people could not qualify itself as sovereign in the traditional sense of the word. Before claiming any status, ‘sovereign’ countries should try to achieve economic independence, and in the current global economy that goal can only be obtained by cooperating with their equals. Most developed and, in my view, the most sovereign nations are those that have stopped claiming that they are completely autonomous, have learned the game of global cooperation and have played it to their advantage. How can a country claim to be sovereign if it needs to borrow foreign capital to feed its people? After all, isn’t integration, a form of sovereign waiver that has proven profitable for European and North American nations? Cooperation can make countries, to a certain extent, dependent on their trading partners, but it will also give countries more resources to provide for their people and, to the extent possible, exercise their autonomy. Sovereignty today should be measured in terms of how free a nation is to select its trading partners, but trading partners will undoubtedly be always present in the modern conception of the word.

Today the conception of sovereignty has changed in Latin countries. Argentina removed a classic form of sovereignty by voluntarily converting the local currency into dollars. No longer can politicians and the central bank feed inflation by manipulating the exchange rate and wantonly expanding domestic credit. Despite some recent criticism, the local government believes that the peg of the peso to the Dollar continues to work as it always did, which is just a reaffirmation that nobody in Argentina at least, feels insulted if the conception of sovereignty has been rewritten. Venezuela did something similar to Argentina when enacted its new Constitution last year, it eliminated a 30 year old provision that maintained that foreign debt agreements could only be governed by national laws. Additionally, the Constitution expressly subordinated local laws to supranational regulations and entities with a view to actively participate in the regional integration movement. This change in views is an admission that even in countries where the traditional concept of sovereignty is still politically strong, its absoluteness has been rethought.

The same attitude should be taken when conceptualizing forms of international debt obligations. We know that sovereign is not a scientific term, but a pure philosophical concept and, as Dr. Stephen Hawking say, "the sole remaining task for philosophy is the analysis of language". This is what we have tried to do in this note: To analyze the current usefulness of the traditional concept of sovereignty, and because analysis is very good for description, but not for action, we have also tried to discourage its use in the context of Latin American international debt.

Sovereign bonds today should not be understood as something related to the traditional sense of the word, but just as a noun to distinguish them, to the extent possible, from similar corporate instruments. Without trying to revolutionize anything, a name like government restructured bonds, or national restructured bonds maybe more accurate than sovereign bonds. Even if you disagree with our suggestions, you should remember that the absolute sovereignty of the bonds has actually been waived.