Emerging Markets

Somehow, all three are linked together today in my mind. And at some level, they do all connect. As Martin Wolf notes, Asia’s current account surplus (savings surplus) shows up in the phenomenal growth in Asian central bank reserves (which are actually increasing more rapidly than Asia’s current account surplus as a result of private capital inflows). Tuesday’s Wall Street Journal observed -- accurately -- that Korea is looking to boost the yield of its reserve portfolio by holding a more diverse set of financial assets (though not a more diverse set of currencies, we are told). One way to get a higher yield than plain vanilla paper is to invest in collateralized debt obligations --a subject discussed in Tuesday’s Financial Times ... All three articles also raise important points for those concerned about the health of the international financial system. Martin Wolf’s excellent essay takes a lot of themes that we have discussed here, and pulls them together into a coherent picture. In my view (no doubt biased, since he cites Roubini), Wolf gets all nuances right. The US has outsourced savings to China, and East Asia more generally. East Asia, has, in a sense, outsourced consumption to the US. Each needs the other. But since the US saves way too little (and consumes too much) and East Asia consumes too little (and yes, saves too much), the situation is ultimately unsustainable. It is vitally important to move over time to more balanced and healthy economic relationship. Yet extricating the US and East Asia from their current unhealthy and unbalanced embrace will require a rather delicate touch -- something the Bush Administration is not noted for. It also will require a willingness on all parties involved to look inward, not just to blame the other guy -- something that so far seems lacking on both sides of the Pacific. The best evidence that the current situation is unsustainable? The current flow of private capital. To sustain current account deficits of its current magnitude, all of the world’s surplus savings (the global current account surplus) needs to flow to the US. Yet private investors are putting a lot of their money in emerging Asia, not to the US: They would prefer to fund some of Asia’s investment than to fund the lack of savings in the US. Private investors are inviting Asia to draw on their savings so that Asia can consume more today (i.e. save less) and still invest the same amount. Wolf correctly notes "the private sector has been trying to push emerging market economies into current account deficit." Asian central banks, however, are getting in the way. They are taking the funds flowing into Asia, along with Asia’s own excess savings, and investing them in the US, making it possible for the US to get away with next-to-no household savings and a structural budget deficit. But this is a dangerous foundation for today’s the world economy. Why? Look at the Wall Street Journal’s examination of the dilemmas facing Korea’s central bank on Tuesday (p. C1). There are two reasons why Korea is less comfortable adding to its already substantial reserves than China. First, it is a democracy, and, if the central bank is borrowing in won to invest in depreciating dollars, it has to explain itself. Second, Korea has to pay more to "sterilize" its reserve inflows than China, for reasons that I’ll discuss at length in another post. Indeed, on a cash flow basis, the Bank of Korea paid more in interest on its sterilization bonds than it earned on its reserves. To quote the Journal: The Bank of Korea posted a loss last year of $150.2 billion won ($147.5 million). It was the first central bank deficit since 1994, and was largely the result of issuing so called monetary stabilizatoin bonds in an effort to sterilize, or offset, foreign capital inflows. Losing money on every dollar of reserves makes you think twice about adding to your reserves. And, more immediately, it is pushing the Koreans to "reach for yield" and invest in a wider range of assets. Who knows, they might even be buying Collateralized Debt Obligations (CDOs, essentially repackaged corporate debt), or even Synthetic Collateralized Debt Obligations (don’t ask for an explanation, just read the FT). It seems like everyone else is. Presumably, central banks would buy the safer, high-rated tranches of a CDO, not the riskier, higher-yielding tranches. A CDO more or less takes a group of moderately risky loans and transforms the underlying loans into a set of new "loans," typically, a relatively safe loan, a moderately risk loan and a very risky loan. Each of these parcels of the original set of loans -- usually called a tranche -- is backed by cash flow from the moderately risky loans, unless the investment bankers get fancy. I am not convinced that collateralized debt obligations are reducing systemic risk by spreading risk around toward those most able to bear it. I tend to agree with an unnamed policy maker (central banker?): We are in uncharted territory ... if a crisis hits, we think the market will absorb shocks smoothly -- but the truth is no one knows. I don’t necessarily take comfort in the fact that "real money" types are buying the safe parts of the CDOs, while hedge funds and other leveraged types are buying the risky parts. I worry that already leveraged hedge funds are buying instruments that themselves sometimes have a lot of embedded leverage. It may be that the hedge funds really do know how to hedge their risks, and thus are not as exposed as it would seem. But big risks are sometimes taken by investors looking for high returns to justify high fees in an environment where there is less and less easy money to be made ... Remember, historical correlations do not always predict future correlations. I’ll give one example. If memory serves, Brazilian and Russian debt were highly correlated before 1998 (both profited from global interest in emerging market debt, and both had fixed exchange rates and active domestic debt markets). They were not so correlated in 2002 (When Brazil almost melted down and Russia did not). And they probably were quite correlated in 2004, as both benefited from China’s insatiable demand for commodities, along with a benign global interest rate environment. My point: hedges based on the assumption that historical correlations will hold in the future can break down. Then again, I am more inclined to see a half-empty glass than a half-full glass. Apologies for veering off into financese, which can be worse than economese ...

Brad DeLong is rather skilled at squeezing the fat off a post, and then creating something that is sharper, more succinct and often far better than the initial post. I know. He does it to me every now and again.One of his recent posts keyed off something I wrote, before heading off into an extended discussion of how the presence of "very large actors ... not in the business of maximizing their profits" (i.e. central banks)influences world markets. Central bank buying has a direct impact of course, but it also has an indirect impact: it can help shape the expectations of the people placing private bets. James Surowiecki of the New Yorker explores similar themes, in wonderfully clear and accessible language: More than any other nation in history, the United States depends, economically, on the kindness of strangers. Right now, Asian investors appear very kind. Markets are hardly known for their tenderness. Usually, you can assume that everyone in a market is trying to make as much money as possible, with as little risk, but the currency market isn’t like most others. In the market for the dollar, many of the players have other things on their mind. China needs to go on selling Americans hundreds of billions in exports in order to keep its economy humming. A weaker dollar makes that harder. Asian central banks also already own trillions of dollars in American assets. As the dollar falls, so does the value of those assets. There are plenty of other traders in the currency markets—who have the luxury of being single-minded regarding profit—but the Asian banks are powerful enough to be, in effect, the lenders of last resort. As long as it’s in their self-interest to keep America afloat, the dollar will not crash. I won’t try to match Surowiecki’s prose style, or attempt to do an abridged version of Brad Delong’s post. Instead, I want to make two, related (wonky) points: 1) The statistical appendix to the IMF’s WEO gives us the raw data that underlies talk of a "global savings glut" -- which really means lots of demand for fixed income assets in the US and Europe, and thus low real interest rates. Reserve accumulation of emerging economies and developing countries has gone from $87 billion in 2001 to $151 billion in 2002 to $297 billion in 2003 to an incredible $436 billion in 2004. Just for the sake of comparison, remember that back in 1997, before the emerging market bubble burst, net private capital inflows to these countries totaled $212 billion. It was the withdrawal of those private inflow led to crises in Asia, Russia, Brazil and elsewhere (Net private flows fell to $107 billion in 98, $59 billion in 99 and $46 billion in 00). The world certainly felt the impact of a $150 billion net fall in private sector financing of emerging economies. And right now central banks in emerging economies are injecting twice as much into the markets of the US and Europe in 2004 as private investors injected into the emerging markets before the 97 crash. The IMF data on emerging economies excludes the Asian NICs, so the total inflow from Japan, Asia and the rest of the developing world into the US and European markets is even larger. Korea, Taiwan, Singapore and Hong Kong added $96 billion to their reserves; Japan added $177 billion to its reserves. Add it all together, and you get total reserve accumulation in Asia (including Japan) and the developing world of $709 billion (including valuation gains). Suppose the world’s central banks bought $400 billion in long-term dollar denominated securities with that money and added $100 billion to their dollar bank accounts (which the banks in turn may have lent to a hedge fund seeking to gear up its own bets on the US fixed income market). $400 billion is not trivial in relation to the $1150 billion in (net) US long-term bond issuance in 2004. And as far as I can tell, right now, total reserve accumulation by emerging economies (including the Asian NICs) is on track to be in the $600 billion range this year (roughly $125 billion a quarter from the big countries in emerging Asia, Mexico, Brazil and Russia produces $500 billion, and the IMF forecasts $80 billion in the reserve accumulation by countries in the middle east). That is a lot of kindness from (poor) strangers. I still think the big question in the global economy is when will the bubble in emerging economy reserve accumulation burst: it is not necessarily a good thing if your largest customer can only afford to buy your products on your credit. 2) As both DeLong and Surowiecki note, central bank intervention, if successful, also shapes private-sector decision-making. Anyone shorting the Treasury market has to consider a range of risks. A soft patch in the US is certainly one of them. But massive intervention by foreign central banks that leads to huge influx of dollars into the Treasury market in the face of renewed dollar weakness is another. The markets often have short memories, but I suspect many remember well the impact of Japan’s 2004 intervention. If hedge funds are indeed replacing dollar funded carry trades with yen funded carry trades (effectively, a bet that the interest rate differential between long-term dollar denominated debt and short-term yen denominated debt is large enough to offset the risk of dollar depreciation against the yen), then the hedge funds are doing exactly what the Japanese Ministry of Finance (the MOF) wants them to do: they, not the MOF, are taking the risk of future dollar depreciation. Private flows replace official flows, but those private flows are premised on an expectation that official intervention will limit the downside risk of certain private bets. After all, making a leveraged bet on the currency of a country with a 6.5% of GDP current account deficit is not the easiest way in the world to earn a living ... Back when I first started blogging, I tried to use the conceptual framework laid out in one of Nouriel’s more theoretical papers to explore some of these issues. The crux of the argument is simple. IMF bailouts (or rescues) can work even if the amount of money the IMF puts on the table is small relative to gross private claims on a crisis country if the IMF’s financing changes market expectations. I suspect that foreign central bank intervention on the current scale is also large enough to shape the expectations of the banks, hedge funds, pension funds, insurance companies and private individuals that make up the broader market. That’s one reason why it is hard to estimate the overall impact of central bank actions.

The best thing the Institute of International Finance does is put together data on private capital flows to emerging economies.They just released their estimates for net private flows to the set of emerging economies that they track for 2004: their data covers most of the key players, at least outside the Middle East.Was private capital -- that global savings glut -- flowing to the US to help finance the US current account deficit? Yes and no. Net private flows to the US were somewhere between $250 billion and $300 billion. We won’t know for sure until the BIS publishes its data on dollar reserve accumulation for 2004. That is not enough to finance a current account deficit of more than $665 billion. Net private flows to emerging economies were comparable to net private capital flows to the US. They totaled $303 billion in 2004. But, unlike the US, emerging economies did need this capital inflow to finance a current account deficit. They collectively ran a current account surplus of $170 billion. That means that they had $473 billion to play with. What does the IIF think they did with this money -- a) paid $28 billion back to the IMF, the World bank and other official lendors. b) bought gold, and otherwise sent $54 billion back out of their economies (this includes lots of private capital flight from Russsia) c) increased their foreign exchange reserves by a whooping $392 billion. The rise in private capital inflows to emerging economies -- they rose from $120 billion in 2002 to $303 billion in 2004 -- fueled the rise in emerging economies’ reserve accumulation from $151 billion in 2002 to $392 billion in 2004. Over the same time, emerging economies aggregate current account surplus only increased by $91 billion. Put differently, emerging economies could not grow your reserves by $392 billion on the back of a $170 billion current account surplus alone; they also needed to be attracting large net inflows of private capital. Private investors want to invest (almost) as much in China as in the US. But China does not need their money; it already save more than it invests at home. So it stockpiles the foreign capital inflow in its reserves, and uses its growing reserves to finance the US. What does this all mean: More private capital flows to emerging economies = more reserve growth, and more financing for the US. Less private capital flows to emerging economies = less financing for the US. Emerging economies opt to spend rather than save this capital inflow = less financing for the US. What happens if private capital inflows to emerging economies start to finance private capital outflows rather than central bank reserve accumulation? My best guess: less financing for the US. Private investors probably will want a more diverse -- meaning less dollar-heavy -- portfolio. Both emerging Europe and emerging Asia attracted large net flows of private capital last year. But the IIF data slo illustrates that there were big differences in how they used those inflows. Emerging Europe ran (in aggregate) a small current account surplus: Russia’s oil-driven surplus offset deficits elsewhere. Sum everything up and private capital flows to this region financed private outflows and reserve accumulation in roughly equal measure, along with some payments to the IMF (by both Turkey and Russia). However, the aggregate picture is clearly misleading: Russia ran a large current account surplus that financed both reserve accumulation and private capital outflows. Other countries in emerging Europe used private inflows -- mostly from the rest of Europe -- to finance current account deficits. Call it a success for European integration: the flow of capital inside Europe went from rich to poor, and probably also from old to (relatively) young. Emerging Asia looks a bit different. It also attracted large capital inflows. But unlike emerging Europe, it also ran a large current account surplus. In made some small payments back to the IMF and World Bank, but there were not large private capital outflows. Instead, everything got socked away in reserves. The $290 billion in reserve accumulation the IIF reports for seven emerging Asian economies is about 1/2 of global reserve accumulation. That total, incidentally, excludes the reserve accumulation of Taiwan, Singapore and Hong Kong as well as a host of smaller Asian economies. Total Asian reserve accumulation was higher, even leaving out Japan. The real question, of course, is whether this game continues. The most recent data release from the Fed suggests it has. The Fed’s custodial holdings -- which only capture a portion of all central bank reserves invested in the US -- rose by $27 billion in March (end February data v. end March data), and are up $56 billion in q1. Annualized, that is a $224 billion annual pace - a bit slower than the $269 billion increase in the Fed’s custodial holdings in 2004. But Japan has been out of the market -- so all the reserve increase is coming from emerging economies. And some emerging economies -- like China -- are quite keen to disguise their purchases, and thus don’t always go through the Fed. Mon cher General: the world does not just consist of Japan and Europe. To finance a $850 billion plus current account deficit, the US needs help from all over the world ... too bad the IIF data does not help us understand better what the petrosheiks in the Gulf are doing.

Brazil believes it can fully repay the IMF in 2007. That is good news indeed.Brazil first received large sums from the IMF in 2001, got much more in 2002 and still a bit more in early 2003. So, if all goes to plan, Brazil will repay the IMF (in full) after six years. That is a longer than the three years that the IMF demands (in theory) for large-scale loans made through its crisis response facility (that facility is called the SRF). Brazil would not have been able to repay the IMF on the 3 to 5 year time frame associated with the IMF’s normal "lending facility " for smaller-scale lending (a "Stand-by arrangement or SBA) either. Turkey, which got an far bigger IMF loan relative to its GDP than Brazil, is likely to take even longer. Full payment may happen in 2008, if all goes well -- but the IMF program currently under negotiation would give Turkey until 2010 to finish repaying the series of loans it started taking out in late 2000. Brazil’s has not repaid even though every thing went very well in Brazil. Brazil has done its part, sustaining large primary surpluses (government revenues in excess of non-interest spending). And Brazil got lucky too: Chinese-fueled demand led to huge price increases on for its iron-ore and soybean exports; exceptionally low US interest rates which made Brazil a far more attractive investment destination than it otherwise would have been. So why couldn’t Brazil repay the IMF more quickly, on something like the terms of the IMF’s crisis response facility? Simple: Brazil has lots of debt, mostly domestic, and relatively low reserves for an economy of its size -- it needed the IMF’s money to allow it time to grow out of an (almost) unsustainable debt burden, and to allow it time to rebuild its reserves. It was never realistic to think that Brazil only needed a very short-term loan. The same is even more true of Turkey: without external financing from the IMF, Turkey’s domestic debt dynamics would have exploded a few years ago, and would not look that good even today. This is one of the issues Nouriel and I tried to highlight in our book on responding to financial crises in emerging economies: if the IMF to going to be used to help out (or bail out, depending on your point of view) emerging economies with far more debt than Mexico or Korea, the IMF -- realistically -- is not going to get repaid all that quickly, even when everything works well. However, the IMF’s shareholders (led by the US, but the rest of the G-7 are also implicated) remain reluctant to recognize reality. They don’t want to align the terms of the IMF’s lending facilities with the actual lending that the IMF is doing. They prefer to pretend that the IMF won’t be making any more big loans. And if the IMF should make a large loan, they also like to pretend that such lending really can be repaid quickly and thus can be made through the crisis response facility - even the IMF is lending to countries as indebted at Turkey and Brazil. Dream on. It is not the end of the world if a country cannot repay on the IMF’s original terms. The IMF can always refinance. But it still has consequences. Funds lent out to one country for an extended period are not available to lend to other countries. And critics can claim that the IMF is not being true to its (stated) mission of providing short-term financial support ...

I suspect most people who read this blog are interested in the dollar, US interest rates, the trade balance, the "hard v. soft landing debate" (outsourced today to Kash at the Angry Bear), oil, even systemic risk in US financial markets.Retrospective analysis of what went wrong in Argentina back in 2000 and 2001 is probably not so high on most reader’s list of interests. But Argentina’s crisis was a searing experience for me. In my no doubt biased view, the case studies are the real strengths of this just released IMF paper (fully disclosure: I contributed to the Argentine case study). Each case study shows how balance sheet analysis can be applied to better understand crisis dynamics -- or the absence of crisis dynamics. All were written by some of the best (young) economists at the IMF (but again, I may be biased). The Argentine cases study tries to show, concretely, why delay was costly, and specifically, how the balance sheet of Argentina’s banking system evolved during the course of 2001. The core thesis of the Argentine case study is simple: Argnetine’s banks were in far better positioned to survive a devaluation and a government debt restructuring at the end of 2000 than they were at the end of 2001. Consequently, waiting a year had real costs. Interestingly, the deterioration of the banking system’s resilience was NOT primarily the result of new lending to the government. The banks extended far more credit to the government in 1999 and 2000 than they did in 2001. Indeed, that, in a sense, was a core cause of the government’s trouble: depositors were pulling funds out of the banking system, and a shrinking banking system could no longer extend credit to the government to help cover its ongoing deficits. But even though the banking system’s absolute exposure to the government did not go up, its relative exposure did. Its credit to the government rose a bit, while its deposit base shrank massively. By the end of 2001, lending to the government made up a far larger share of the banking system’s assets than at the end of 2000. Ironically, during the course of 2001, Argentine banks got rid of precisely those assets that would (potentially) have performed in the event of a devaluation and government debt restructuring. They ran down their best assets -- their liquid offshore reserves -- to pay off depositors (and to pay off maturing cross border credits). They also reduced their peso lending to Argentine firms dramatically. Peso deposits fell more rapidly than dollar deposits (that, incidentally, does not mean dollar depositors did not run: some peso depositors shifted into dollars, and some dollar depositors ran). To stay matched, currency wise, the banks had to reduce their peso lending commensurately. That left the banks with dollar-denominated lending to the government, and dollar-denominated lending to Argentine firms. Both types of lending were almost sure to go bad in the event of a restructuring and a devaluation. Most of the banks’ dollar lending was not to firms in Argentina’s (small) export sector. Remember, so long as the peg lasted and Argentina’s exchange rate remained overvalued, the export sector was, generally speaking, a bad bet. Rather, most of the banks’ dollar lending was to firms with peso revenues. Those firms may have been foreign-owned utilities, but they were still bad bets, with mismatched revenues and liabilities. Any political risk assesment would have indicated that the utilities were not going to be able to continue to index their prices to the dollar after a devaluation. There are more details and twists in the case study -- and similar in depth treatment of Uruguay, Brazil, Lebanon, Turkey and Peru.

Zhou Xiaochuang, China’s central bank governor, ruled out a revaluation to "to rectify bilateral trade imbalances."Fine. But China’s overall trade and current account surplus looks set to explode. A $30 billion global trade surplus can be argued away, but not a $100 billion plus surplus. Is he also willing to rule out a revaluation to address a broader set of imbalances?Zhou, of course, can not say that China is planning to revalue. If China changes its policy, it wants to surprise the market. However, I don’t quite get China’s emphasis on "flexibility" rather than a "revaluation." I presume the formulation was initially meant to buy China a bit of time: we cannot move towards more exchange rate flexibility safely until we fix the financial system and create a functioning fx market that allows our firms to hedge, and that will take time, so back off ... But I increasingly suspect that time, rather than making China’s financial system stronger, is making it weaker. Sterilizing $200 b plus of reserves ain’t easy. Check out the PBOC’s balance sheet, and note the huge increase in sterilization paper in 2004. China’s keeps the costs of sterilization down by forcing the (state-owned) banking system to buy low-yielding central bank paper. But how exactly does that make the banking system stronger? The only reason I can come up with is that China’s banks will ultimately be better off lending to the government at their cost of funds rather than lending to fuel China’s various domestic bubbles, where they ultimately will lose money ... One other (technical) thought: many emerging economies have gotten into financial trouble by borrowing in dollars to finance domestic projects. If the local currency falls in value, the real value of these dollar debts does up, causing trouble for borrowers and lenders alike. China obviously does not face that risk. But what about the opposite risk, namely borrowing in local currency against dollar or euro export revenues. 35% y/y export growth cannot continue indefinitely, and firms that borrow in renminbi to build export capacity potentially face trouble in the event of a renminbi revaluation. In the short-run, that may argue against any revaluation. But letting the current system run means that the domestic financial system’s renminbi exposure to firms with dollar (and euro) revenue will continue to climb. I am not sure this is a real risk, but I am starting to wonder.

DeLong is clearly working his way through Paul Blustein’s book on Argentina. Martin Wolf has a column on Argentina’s restructuring in yesterday’s Financial Times, which I quite liked, for rather obvious reasons. Blustein puts a large share of the blame on Argentina’s failure to run a more prudent fiscal policy in the late 1990s. I would put equal, if not more, emphasis on Argentina’s currency board. The currency board tied the peso to the dollar. That became a real problem after 1999, if not before. The dollar was strong and getting stronger back then. Soybeans (Argentina’s main export) were not doing so well. After Brazil devalued the real in early 99, it was pretty clear that the Argentine peso was substantially overvalued. Without devaluation, real exchange rate adjustment had to come through falling domestic prices (deflation), and that meant a long, sustained recession. Argentina wanted to grow out of its public debt difficulties, but the needed growth was hard to square with the deflation needed for real exchange rate adjustment. Moreover, high levels of external debt and rising interest rates on that debt meant that Argentina needed to start generating trade surpluses to pay interest on its debt, not just pay interest with new borrowing. That too implied that real value of the peso had to fall. Running up your external debt is usually more fun than paying it back. A more responsible fiscal policy in the mid 90s would have meant less external debt, and maybe with less debt all around, Argentina could have held on until the dollar started to fall and soybean prices started to rise. Maybe. I personally doubt it. Remember, the dollar has not fallen all that much v. the all important Brazilian real since 2000. The real has appreciated recently, but only after falling a lot in 2002. The Washington Post also has chimed in with an oped arguing that Argentina’s restructuring took too long, and that an international bankruptcy regime might have made for a faster restructuring process. The deal took too long to organize, unnecessarily hurting both lenders and Argentina. ... This is why the world may eventually create something like a bankruptcy court for dealing with governments. If Argentina were a company, a bankruptcy judge would have taken control of the debt workout, cutting out the need for a three-year game of chicken between the country and its creditors. Once a proposed debt write-down had won the support of a majority of creditors, the minority would have been left with no option to reject the deal, whereas now creditors representing a quarter of Argentina’s debt still refuse the offer. This delay and uncertainty serves nobody. Anne O. Krueger, the No. 2 official at the International Monetary Fund, put the idea of a sovereign bankruptcy mechanism on the table in 2001. She should return to the subject. I certainly agree that it took too long to get a deal, though I suspect that with a different policy approach, the IMF and the US Treasury could have pushed Argentina to initiate its restructuring a bit faster even without an international bankruptcy regime. I also am all for legal changes that make it a bit harder to holdout from a restructuring that most creditors are willing to accept. Realistically, though, the "aggregation clauses" in Uruguay’s and now Argentina’s new bonds hold more promise than a revived international bankruptcy mechanism. (aggregation = the ability to combine the votes of multiple bonds in a restructuring) But I am also wary of overstating the impact of a new and one would hope better legal process. The link between an "orderly legal process" for sovereign debt restructuring and an "orderly" sovereign debt restructuring is not as tight as many claim. Uruguay showed that it is possible to have a relatively orderly sovereign debt restructuring even in the absence of bond clauses or an international sovereign bankruptcy regime. In the right circumstances, bond swaps work, no matter what the legal regime. And I suspect that, in Argentina, an "orderly legal process" for bond restructuring would not have generated an "orderly" sovereign debt restructuring. If Argentina had waited until the end of 2001 to initiate its restructuring, the process would have been messy no matter what. By then, Argentina had too few reserves, too many dollar deposits that the banking system could not honor, too much dollar-denominated domestic debt and too much external debt. An orderly external debt restructuring, given the scale of the needed debt relief, was not in the cards. And a better process for external debt restructuring would not have dealt with the biggest problems Argentina faced going into 2002: enormous domestic debts and a frozen banking system.

I do not expect to consistently agree with the oped page of the Wall Street Journal. But I do not think it is too much to ask that the columnists on oped page of the Journal try to square their arguments with reality, not with a cartoon version of reality.Mary Anastasia O’Grady’s column today is centered on a cartoon version of reality -- a world where the "Clinonistas fueled moral hazard by bailing out Wall Street cronies, who were up to their ears in high yielding debt," a world where the IMF "lost political support for unrestrained lending to insolvent governments -- aka bailouts" after Argentina’s default in 2001, and a world the "IMF’s good housekeeping seal of approval on Argentina" was the only reason why "markets pumped in money so liberally." All three arguments are myths. 1) The claim: "The Clintonistas" fueled moral hazard by bailing out Wall Street cronies" The facts: The Clinton Administration pulled the plug on the IMF’s bailout of Russia in the summer of 1998 after only $5 billion of the roughly $15 billion IMF package ($20 billion including the World bank and others) had been lent out. As Rubin’s memoirs make clear, this was not an easy decision. Russia was considered too nuclear to fail for a reason (Argentina, in contrast, is "a dagger pointed at the heart of Antarctica, to use Kissinger’s memorable phrase). But Rubin strongly believed that there was no point throwing good money after bad; he prevailed against the rest of the NSC, which wanted to keep on lending. "Wall Street cronies" were left holding lots of exposure to Russia -- whether ruble denominated GKOS or London Club debt. Russia’s default certainly should have eliminated any expectation that every country would get a bailout large enough to let Wall Street get off scott-free. A bit of math. In 1998, Russia got $5 billion. At the time of its devaluation and default, Russia had at least $50 billion in GKOs/ OFZs outstanding (not all held by foreigners, but foreigners are also not the only ones bailed out by the IMF), around $30 billion in London club debt, and a few eurobonds as well. $5 billion in GKOS may have gotten off the hook courtesy of the IMF, but the $80 billion that remained and was restructured "learned" a lot about the risk of lending to emerging economies. But there are other examples as well. The Clinton Administration did not bailout bondholders in Pakistan, Ukraine or Ecuador -- all of whom had to restructure their debt. And in Korea, after the initial bailout package failed, the Clinton Administration decided to rope in the banks, and pressure them to roll over their loans -- not to provide all the funds needed to let everyone get out. Compare that with the Bush Administration in Turkey: throughout 2001, international banks were cutting their lending to Turkey as the IMF was putting its money in. The correlation is almost perfect: the IMF put $13.2 billion into Turkey in 2001, the banks took $11.5 billion out. I call that a bailout. The Bush Administration, for ideological reasons, was opposed to putting any pressure on the banks. 2) The claim: "IMF lost political support for unrestrained lending to insolvent governments." The facts: If there ever was a case of clearly lending to an insolvent government, it was the Bush Administration’s decision to push for a $8 billion expansion of the IMF’s bailout of Argentina in the summer of 2001. At the time, it was pretty clear -- as clear as it is ever going to be -- that Argentina was effectively insolvent, and eventually was going to have to forcibly restructure its bonds. The Bush Administration pushed for this loan, the rest of the G-7 was not so keen. $5 billion of the $8 billion augmentation was disbursed -- so the augmentation alone provided about 1/2 of the $10 billion (net) that the IMF provided to Argentina (The Clinton Administration had approved a $15 billion loan in December 2000. However, that loan was comparatively back loaded -- about $5 billion of that loan was not disbursed -- and a large fraction of the IMF’s lending just refinanced payments coming due, so the net disbursements from this loan in 2001 were only around $5 billion.) For a full account, see Paul Blustein’s new book on Argentina’s crisis. Moreover, the Bush Administration kept on backing large IMF loans to quite indebted countries AFTER Argentina defaulted. Turkey got a huge package ($18 billion) in 2002. Brazil got an even bigger package -- $30 billion -- in 2002. Uruguay got $3 billion, which does not sound all that impressive until you realize that $3 billion is about 15% of Uruguay’s GDP. All three countries had very high levels of public debt. And if you doubt my argument, do look at what happened to the amount of IMF loans outstanding in the course of 2002 (data is, alas, in SDR). Let me put this way: outgoing Treasury Under Secretary John Taylor did not get a medal from the Uruguayans for saying no to their request for help. 3. Claim: the "IMF’s good housekeeping seal of approval" explains why the markets dumped money at Argentina. The previous arguments are easy to document by looking at the IMF’s balance sheet. This one is a bit harder -- I certainly don’t know for sure why investors lent so much to Argentina in the 1990s. But I do know this: anyone who lent to Argentina after Russia did so knowing that no country was guaranteed access to enough IMF money to avoid default, and did so knowing that if they held a long-term claim, like a bond, they probably were not going to be able to get out on the back of the amounts of money the IMF typically makes available. Holders of short-term creditors have a better chance of getting out on the back of IMF lending, or the country’s own reserves. Holders of a ten year bond cannot get out until the bond matures. They can sell their bond -- but that just shifts its ownership. Ecuador’s 1999 default and restructuring made it absolutely clear that bonds were not exempt from being restructured. The IMF also -- as Paul Blustein documents -- issued some rather public warnings (by IMF standards) in the spring of 1998, warnings that the markets brushed off. I think the IMF should have been a bit louder, but it is a bit rich to attribute all bad investment in emerging economies to the IMF, and not put any blame on the markets own tendency to reach for yield. Or, to put it differently, is the current wave of lending to emerging economies a product of the Bush Administration’s willing to use the IMF to bail out Uruguay, Brazil and Turkey, which, in turn, has triggered a new wave of moral hazard induced lending? Or is it a product of low yields in advanced economies, cheap short-term money and the carry trade? A final note: most of the data referenced here comes from the book Nouriel Roubini and I did on crises in emerging economies, which, as this weeks’ Economist notes, if nothing else, is "admirably thorough." In that spirit, a couple of notes of caution to those in the press who are now comparing the 32 cents creditors "recovered" on Argentina with the higher recovery value in Ecuador and Russia. 1) Russia restructured both its "London Club debt" (dollar denominated, Soviet era syndicated loans) and its GKOs (ruble denominated treasury bills). Doing the calculations on the recovery value for the ruble debt is a bit difficult, but it clearly was a lot lower than the 50 or 60 cents on the dollar investors "recovered" in the London Club restructuring. I suspect GKO investors did no better, and may have done a lot worse, than Argentina’s bond holders. Incidentally, Russia left its "true" eurobonds entirely out of its restructuring, though the distinction between the "London Club" debt and a eurobond is a rather fine one. 2) Doing the calculations for the recovery value on Ecuador is extremely difficult, because Ecuador had so much collateralized debt. Lots of the "recovery" came simply from releasing the collateral in Ecuador’s pars and discounts. The holders of Ecuador’s uncollateralized Eurobonds (maturing in 02 and 04) did extremely well, no doubt (they got to swap at par into a new 12 bond that paid a 12% coupon). The holders of the uncollaterized payment streams on the Bradies (A collaterized Brady bond can be broken down into two components, the collateralized principal, and the uncollateralized interest payments, and the stripped spread on the uncollateralized component can then be calculated), in contrast, did not do very well at all. No doubt, Ecuador’s restructuring was more generous than Argentina’s. But about 1/4 (15 cents) of the overall 60 cents recovery value came from the release of the bond’s collateral (Assuming a market value of the restructured bonds + collateral + cash payments of about $4 billion, which works out to about a 60 cents recovery value -- I have data on the terms of the new instruments, not on the market valuation of those new instruments. My point: some claims made by Argentina’s bondholders rely on a selective reading of the history of past bond restructurings. Holders of GKOs did not get 50 or 60 cents on the dollar; holders of Ecuador’s uncollateralized Brady payment streams did not do all that well either (Holders of Russia’s eurobonds and Ecuador’s 02 and 04 bonds, in contrast, did quite well). Ecuador most certainly did not "negotiate" with a bondholders committee; at the time, bond holders complained loudly about the unfairness of Ecuador’s take it or leave it exchange.

Argentina is on the verge of completing one of the largest sovereign debt restructurings in history. Argentina is seeking to restructure about $82 billion in bonds, plus $21 billion or so in past due interest. The biggest preceding bond restructurings were Ecuador ($6.5 billion) and Uruguay ($4 billion of international bonds) -- so Argentina’s restructuring is absolutely massive. It dwarfs Russia’s 2000 restructuring of about $30 billion in international sovereign debt. (technically, Russia restructured syndicated bank loans, not bonds, but since lots of the loans had been sold into the market, the difference between bank loans and bonds was bit blurred). Investors had until Friday to tender their bonds in the exchange. The final results will be announced next week. Recent estimates suggest that 75%, maybe more, of all eligible debt participated in the exchange. Investors who participate in the exchange are giving up their legal right to full payment of principal and all past due interest. But since the legal right to full payment is nearly impossible to enforce, investors effectively are giving up an old bond that won’t be paid for a new bond that Argentina should pay. The catch? Argentina offered a maximum of $42 billion in new bonds in exchange for roughly $82 billion in old bonds. Or, to think of it a bit differently, the market value of the old bonds was about $26 billion ($82 billion face worth roughly 32 cents on the dollar). If all holders of old bonds swap into new bonds, the new bonds will also be worth about $26 billion ($42 billion face, and an average price of 62 cents on the dollar), and probably a bit more if there is a post-restructuring rally. So investors are recovering only a bit more than 30 cents on their original dollar, assuming they initially bought the bonds at par. Argentina, consequently, is about to carry off not just a big restructuring, but also to get substantially more relief from its creditors than debtors have gotten in previous debt restructurings -- something that Argentina’s President, Nestor Kirchner, never hesitates to point out. Kirchner clearly thinks the deal is a good thing for him. But is it a good thing, or a bad thing, for the broader international financial system?Some -- and not just creditors with skin in the game -- argue that Argentina’s exchange is nothing more than a mugging of creditors. Walter Molano, quoted in this Reuters story, is typical of those who worry that Argentina is setting a terrible precedent: "There are a host of countries waiting in the wings to see what happens with the Argentine restructuring, before deciding how to proceed," wrote Walter Molano. According to this argument, by letting Argentina get away with this exchange, the IMF and the G-7 are undermining the sovereign debt market. Of course, the creditors who opted to participate in the exchange are at least as responsible for the outcome as the IMF and the G-7 (Argentina has not exactly been following all of the IMF’s advice for the past few years). It is interesting that private creditors, who often argued that the IMF should stay out of sovereign debt restructurings, have been desperate to get the IMF to weigh in on their side over the past few weeks. The creditors discovered that they had far less leverage than they initially thought ... Others -- and I clearly am in this camp -- say that Argentina sought more debt relief than other debtors because it ended up in a worse position than other debtors after its default. It went into its crisis with substantial debts generally, and an unusually large amount of external sovereign debt in particular. It experienced an unusually deep crisis -- in part because it went through an exchange rate crisis, a sovereign debt crisis, a banking crisis and a corporate crisis all at once. Argentina’s pre-crisis public debt to GDP ratio of a bit over 50% was a bit deceptive. Argentina’s GDP was valued at a massively overvalued exchange rate before its crisis; at realistic exchange rates, the government’s debt to GDP ratio was more like 80% or even a 100% Consequently, Argentina needed more debt relief than other debtors. This is not to say Argentina could not have made a slightly more generous offer -- I previously have argued that Argentina should have tried to sweeten its offer by putting a bit more cash on the table. That might have increased participation and reduced Argentina’s future legal troubles without risking its future solvency. But while Argentina had room to adjust its offer at the margins, it could not have made a substantially more generous offer without putting its ability to emerge from its cycle of debt and default at risk. Even if all creditors agree to Argentina’s proposed terms, its overall debt levels will remain very high. Its debt to GDP ratio will remain around 80%. Servicing that debt will require that Argentina sustain a primary surplus -- revenues in excess of non-interest expenditures -- of around 4% of GDP. Overall debt levels don’t tell the entire the story. There is a difference between the debt a sovereign government owes to its own people, and the debt it owes to external creditors. Defaulting on domestic debt is defaulting on yourself -- it reduces domestic wealth, and usually devastates the domestic banking system. That is hardly a recipe for domestic political success. Countries with large amounts of domestic debt -- notably Brazil and Turkey -- have made major fiscal adjustments to avoid a domestic default. High levels of external sovereign debt are another thing. External debt implies an ongoing net transfer out of the country: sustaining the political support for that transfer in the face of adverse shocks is hard. According to JP Morgan data, Argentina’s "external sovereign debt to GDP ratio" will remain unusually high even after its restructuring, at 50% of Argentina’s current GDP. That ratio is comparable to countries like Ecuador (35% of GDP) and Pakistan (49% of GDP). It is well above the levels of Mexico (12%), Russia (13%) and Brazil (18%). In my view, high levels of external sovereign debt are sustainable only if the coupon on the debt is low and the debt does not need to be refinanced frequently (as will be case with Argentina), or if the debt is owed to unusually generous creditors, like the Paris Club, who tolerate frequent arrears (see Pakistan) ... Will Argentina’s restructuring set a bad precedent and undermine the broader market. Paul Blustein says no. "I just don’t buy the argument that this will set a precedent for Brazil or Turkey or any other country," said Paul Blustein, author of ’And the Money Kept Rolling In (and Out)’, a new book on Argentina’s economic collapse. "This country went through hell," he said. "Any country that thinks this is a good way to reduce your debt burden is nuts." I tend to agree. More importantly, the evidence suggests that the market also agrees with Blustein. Argentina’s desire for a major debt relief are hardly a surprise. It has been known for some time. If creditors were really worried that Argentina’s restructuring made default and deep debt relief an attractive option, they would either raise their estimate of the probability an emerging market will default or reduce the amount they expect to recover on a defaulted bond. Both would tend to reduce a bond’s value. What actually has happened? The value of almost all emerging market bonds has gone up over the past two years ... hmm. Obviously, this has something to do a global surplus of liquidity, which is leading investors to bid up the price of all fixed income assets. But it is more than that too. PIMCO holds more emerging market bonds than anyone I know of, around $20 billion. Even though they were smart enough to get out of Argentina well before it defaulted, they certainly would worry if Argentina’s default and subsequent restructuring radically changed other sovereign government’s incentives to pay. However, PIMCO looked around the world and did not see emerging markets acting like they wanted to follow in Argentina’s footsteps. Rather, they saw most emerging markets, most notably Brazil, taking steps to enhance their creditworthiness after Argentina’s default. Look at Brazil’s primary surplus, Turkey’s primary surplus, even Ecuador’s primary surplus. Look at the current account surpluses and reserves of most emerging economies, not just Asian economies. This is not to say that Argentina’s restructuring will have no impact. Argentina did not show that default is painless, but it did show that the costs of external default are heavily frontloaded. Heavily indebted countries that have already incurred the upfront costs of default are likely to look at Argentina’s example and be less inclined to rush to do a quick deal with their creditors. But that does not mean all countries in difficulty will emulate Argentina. Some are likely to emulate Uruguay instead, and seek to restructure their bonds on terms that are (comparatively) favorable to creditors to try to buy the time they need to avoid an Argentine style meltdown. Argentina does set a precedent. But it is not the only precedent out there, and it is a precedent that most countries won’t find all that appealing. Be wary of over-generalizing based on a single example. Russia had the biggest sovereign default and restructuring before Argentine. In 1998, Russia defaulted on its domestic treasury bills -- the famous GKOs. Incidentally, international investors held lots of these treasury bills, so it does not contradict my earlier argument about the importance of looking at the share of debt held externally. It defaulted on Soviet era syndicated bank loans. It restructured its debts to the Paris Club. But it did not restructure its international sovereign bonds. Anyone who concluded, based on Russia, that international bonds would be exempt from future restructurings, or would be restructured on better terms than other debt, ended up making a big mistake. Look at Argentina. One interesting point: Even if 80% of all creditors participate in the deal, the holdouts will hold more international sovereign bonds ($16 billion face, over $20 billion including past due interest) than had been restructured prior to Argentina (I am starting the clock for bond restructurings with the Brady plan, which created the modern international sovereign bond market). Argentina’s default is still not entirely behind it. Its lawyers will be in court fighting off legal challenges for a long-time.

David Sanger goes back to his roots as the New York Times’ Treasury correspondent, and outlines the tensions that the dollar’s slide over the past few years has created. Sanger digs up a bunch of old quotes -- along with a few new ones -- to demonstrate the global blame game continues. The euro is too strong -- and euroland growth too weak -- because the Bush Administration has a policy of benign neglect toward the dollar. China’s reserves are growing faster than China wants because, well, because currency speculators are bad people -- not because China’s exchange rate is undervalued and the renminbi is currently a one way bet. The US trade deficit is too big because the rest of the world won’t grow (let’s ignore for a moment that world growth was actually quite strong in 2004), not because US national savings is exceptionally low. But the quote that really struck me was from Treasury Under Secretary John Taylor. Taylor took credit for "containing" the crisis in Argentina, along with crises in Brazil and Turkey. There has not been an economic crisis of significant magnitude since Mr. Bush came to office. John B. Taylor, the Treasury under secretary for international affairs, said that was partly a result of preventive maintenance. "My first days on the job we had a crisis in Turkey and one coming in Argentina and Brazil," he said. "Both were contained." Taylor has every right to claim credit for success in Brazil and Turkey. It has been surprising that the Administration has not trumped these successes more: presumably they are still a bit embarrassed that they contained both crises by throwing big sums of money at fiscally responsible social democrats (Dervis, Lula). That is not exactly the response to emerging market crises the Bush Administration economic team came to office promising. Turkey in particular was no slam dunk. The Administration took a risk, and it paid off -- though saving Turkey required going from providing very large, short-term bailouts to not so indebted countries through the IMF to providing very large, long-term bailouts to quite indebted countries through the IMF. Turkey still owes the IMF a large sum of money. But Argentina? In what sense did the Administration’s policies contain Argentina’s crisis? Argentina’s economy tanked throughout 2001 as the Argentines -- backed by the Fund and the US Treasury -- vainly defended their own cross of gold (the currency board). And then Argentina’s economy tanked some more in 2002, when Argentina made the painful (but in my view necessary) step of getting off the currency board. And Argentina still has not cured its end 2001/ early 2002 default. You win some and you lose some in the crisis business. No one bats 1000. But it is a bit much to claim Argentina as a success. It hardly enhances the Treasury’s credibility.Taylor often argues that the Administration’s response to Argentina in 2001 -- which largely consisted of giving Argentina money to defend the currency board and avoid default -- prevented Argentina’s crisis from giving rise to contagion. In that sense, the crisis was contained. The pain was confined to Argentina. His argument does not really hold water. The bond market has plenty of time to get ready for Argentina’s default, and there was no bond market contagion. But lots of banks were surprised by the scale of their losses in Argentina, and got real cautious in other countries. Bank exposure to Brazil fell like a rock in 2002. That, to me, is a form of contagion. And then there is Argentina’s dirty little secret, or perhaps the market’s dirty little secret. There is a simple reason the "market" reacted so calmly to Argentina’s default: the institutional investors that make up the majority of the US market did not hold that many Argentine bonds by the time Argentina defaulted. Argentina had about $100 billion bonds at the time, an enormous sum. But $50 billion of those bonds (roughly) were in domestic Argentine hands, $25 billion were held by European retail investors and Japanese buy and hold investors, and only $25 billion were held by institutional players (and some of those investors had hedged their credit risk with credit default swaps). That fact -- combined with the fact that EVERYONE in the US market saw Argentina coming -- made it pretty easy for the external bond market to absorb Argentina’s default. Alas, it was not so easy for Argentina’s domestic financial system to absorb the impact of Argentina’s default and devaluation.

An extremely esoteric topic: Paris Club comparability.When the Paris Club grants debt relief to a country like Iraq, it typically requires that the country seek "comparable" debt relief from its other creditors. Iraq consequently is seeking to get both Saudi Arabia (and a bunch of other countries that are not members of the Paris Club) and private investors who bought its old syndicated bank loans (along with its other private creditors)to follow the Paris Club’s lead, and to agree to reduce their claims on Iraq. The underlying logic of comparability is simple: when say the US grants Iraq debt relief, it wants that relief to help Iraq, not to help Iraq pay either Saudi Arabia or a private investor who happened to take a punt on Iraq’s old syndicated bank loans. The question: should this principle apply if a country hit by the recent tsunami accepts the Paris Club’s offer to let it defer debt payments? Lex Reiffel more or less says no in Friday’s FT. I say, yes, the principle still holds, but be flexible in its application. There is one important difference between Iraq and Indonesia that is worth noting. As far as I can tell, the Paris Club is willing to let Indonesia defer payments, not to permanently forgive Indonesia’s debt: money not paid now still has to be paid later. That is not determinative though: private creditors can agree to defer payments too. But should they? In general terms, yes. The goal of the Paris Club’s offer is to make sure than Indonesia (and Sri Lanka) has more money to spend helping the tsunami’s victims, not to provide funds to repay other creditors. But there is no reason to be too rigid either. Indonesia does not -- I think -- have any bonds coming due in 2005, and going through the trouble of restructuring Indonesia’s bond to get a tiny bit of relief on coupon payments is not worth the effort. The fees and the damage to Indonesia’s reputation would outweigh the potential benefits. The Paris Club’s goal should be to make sure private creditors are not taking funds out, not to cause needless stress or a problem where there is not one. I agree with Reiffel on this. I suspect, however, that the government of Indonesia has some commercial bank loans coming due in 2005 (unless something has changed in the last few years, most of these loans will be from Japanese banks). Postponing payment of principal on these loans is an easy way to provide Indonesia with a bit of relief. The loans can be rescheduled formally. Or alternatively, Indonesia could get commitments from its existing creditors to provide enough new financing to assure that there is no net payment of principal this year. That a) is not too hard to do and b) makes sure that Tsunami aid is not used (in some very small way) to pay back commercial banks. An aside: It is true that emerging economies are now attracting substantial private capital flows, as Lex Reiffel notes. But it the aggregate macroeconomic sense, they don’t rely on this capital to fuel their growth. Savings in emerging economies right now exceeds investment in emerging economies, so emerging economies are lending their surplus savings to the developed world (read the US). Capital inflows from abroad effectively finance reserve accumulation, not more investment. FDI plays an important role in diffusing technology and best practices and all that. But, on net, private capital inflows into emerging economies are recycled back to the United States and used to fund the US current account deficit (i.e. US investment in excess of national savings), not to fund investment in emerging economies. Look at Table 25 of the statistical appendix of IMF’s World Economic Outlook. "Emerging economies and other developing countries" have been running current account surpluses (lending to the rest of the world) since 1999 -- and their surplus is growing, not shrinking ... The net flow of capital is from the developing world to the developed world. The "Bretton Woods Two" hypothesis that Asia’s defense of pegged exchange rates will finance the US, so large US current account deficits are not a problem goes a bit too far, but at least the Bretton Woods two thesis -- unlike much writing about globalization -- is consistent with the observed global flow of funds.

Before Argentina’s default, Adam Lerrick thought the IMF (or the G-7) should offer to buy Argentina’s bonds at 60 cents on the dollar. Argentina is now offering bondholders an exchange that will be worth a little more than 30 cents on the dollar. We are lucky that policy makers did not take Lerrick’s advice back in 2001 -- it would have amounted to a $54 billion (think $90 billion in bonds * 60 cents) bondholder bailout. As it is, the IMF only blew roughly $10 billion (net) in a vain effort to try to let Argentina avoid devaluing the peso and forcibly restructuring its debt. One little known fact: since bondholders hold long-term claims, the IMF typically does not bailout them out directly. IMF funds typically are used to let short-term creditors get out. In Argentina’s case, the biggest drain on its reserves in 2001 was a domestic bank run, not payments on international bonds. In today’s FT, Lerrick (who represents a group of Europeans holding Argentina’s defaulted bonds) argues that either the IMF should pony up more money to help Argentina make a better offer to bondholders, or the IMF should take a haircut on its loan. That too would make it easier for Argentina to pay its bondholders more. His views are shared by some -- though certainly not all -- participants in the market for emerging market sovereign bonds. Does his argument hold together? My answer is no.Lerrick argues the IMF lends at "subsidized interest rates 5 to 10% below what the private sector charges." He also argues that the IMF gets paid back when the private sector does not. If that’s the case, the IMF CAN lend at a lower interest rate without lending a subsidized rate. Senior creditors (or preferred creditors: the IMF is paid when other are not as matter of custom, not law) do not have to charge the same rate as junior creditors. By the way, right now the private sector is certainly not charging 5-10% points above what the IMF charges to lend to emerging markets. Large IMF loans given out through the IMF’s main facility for lending to big emerging economies in trouble (the SRF) carry a 300-500 bp surcharge over the IMF’s base rate (now around 3.15), and even large loans given on standard terms (SBAs) carry a surcharge of 200 bp. Right now, the EMBI (the leading emerging market bond index) spread over risk free treasuries is 375 bp, Brazil trades at a bit more than 400 bp. And that is for junior, not senior money ... But the bigger question is whether the IMF should continue to be treated, de facto, as a senior lender. The IMF currently has a portfolio of loans to some of the world’s most indebted emerging economies -- think Turkey, Brazil, Argentina and Indonesia (all the details are in here). All these countries have very high levels of domestic debt, even if some are in better shape than others. The IMF lends its funds -- funds that ultimately come from contributions from the rich countries, notably the G-7 countries -- when private creditors are withdrawing their credit from emerging economies. Without seniority, the IMF would be forced to lend less, and also be forced to charge much higher rates --rates that could contribute to a country’s crisis. I’ll put it more starkly: without the IMF’s seniority, it would have not made a big loan to Brazil in the summer of 2002, and without that big loan, Brazil almost certainly would have been forced into default before Lula proved himself. Emerging market debt would not have enjoyed a stellar 2003 and 2004. The IMF’s bailout of Argentina did not work out for anyone, but IMF lending to Brazil in 2002 worked out well for Brazil, well for the markets and if Brazil is able to repay the IMF during the course of 2005, the IMF too. I agree with Lerrick on one point though. The IMF has not played its (weak) hand well after Argentina’s default. The IMF spent too much time and effort fighting Argentina on peripheral issues, and was never able to reach agreement with Argentina on a macroeconomic policy path that "set the fiscal surplus that determines the cash for debt payments." On the other hand, it is not clear that there was a deal to be done between Argentina and the IMF. Argentina’s current President, Nestor Kirchner, has placed a very high premium on the appearance of independence from IMF. To avoid financial dependence on the IMF, Argentina is now running a huge fiscal surplus. If countries are willing to adopt stricter policies than the IMF demands to avoid the IMF, then the IMF’s direct influence is going to be limited, no matter how well or poorly the IMF plays its hand.

The IMF’s typical diagnosis of an emerging economies problem is "its mostly fiscal", or so the wonky saying goes. Larry Rohter of the New York Times makes the argument that Argentina’s post 2001 success hinges on its heterorthodox economics: I am not convinced. The number one reason for Argentina’s financial and economic stabilization is its belated conversion to fiscal discipline -- or what in the old days might have been called a conservative fiscal policy. Why no hyper-inflation after Argentina’s default? The government matched revenues and expenditures, avoiding the need to print money. Hardly radical. Rohter writes: "Rather than moving to immediately satisfy bondholders, private banks and the I.M.F., as other developing countries have done in less severe crises, the Peronist-led government chose to stimulate internal consumption first and told creditors to get in line with everyone else." The first part is no doubt true. The second half, though, is a bit off: the government has not ran an expansionary fiscal policy after its default. The initial impetus for Argentina’s recovery came from the devaluation, which led to a surge in export revenues (measured in local curency terms), not government policies to spur consumption. Government spending initially had to fall to match falling revenue. The strongest indictment of the IMF is that an Argentine government that explicitly defines its policy in opposition to the IMF has adopted a far more conservative fiscal stance than any Argentina government that embraced the IMF in the 1990s. The world works in mysterious ways: in order to prove that it did not need the IMF, Argentina ended up adopting a more conservative fiscal policy stance in 2004 than the IMF demanded. Argentina’s primary surplus is likely to exceed 4.5% of its GDP (a primary surplus is revenues minus non-interest spending) this year ... Argentina never really was able to run a primary surplus before its default, but I don’t think Argentina could have avoided its crisis just with tighter fiscal policy from 98 on, as many have argued. Argentina’s exchange rate was overvalued before the currency board collapsed. Remember, the dollar was STRONG back then, and Argentina’s 1:1 peg to the dollar meant its currency tracked the dollar, even after Brazil let the real float. Argentina needed to get rid of both a current account deficit and fiscal deficit back in 2000-01: without letting the exchange rate fall, fiscal tightening would only have led to a reduction in the current account deficit if it also led to a broader economic contraction. Bringing the real exchange rate down without changing the nominal exchange rate requires deflation -- and much faster deflation than Argentina was able to muster in 2000 and 2001. Argentina ran a current account deficit in 2001 despite its sharp economic contraction. Argentina’s formula for post crisis success has rested both on its tight fiscal policy, and the impetus given to exports and domestic production by a weak peso. In my view, the IMF -- and by IMF I mean both IMF management and its major shareholders, including the US -- made two mistakes in Argentina. First, in 2000 and 2001 the IMF bet that Argentina could avoid both a devaluation and a debt restructuring. It financed the status quo, when it should have financed the transition to a more sustainable exchange rate regime. Second, in 2002 the IMF bet that Argentina would fail to stabilize its economy after its default and devaluation. Consequently, the IMF ended up betting wrong twice: it bet on success without a devaluation in 2001, and on failure after the devaluation in 2002. That cut into the IMF’s credibility, even if some of the steps Argentina adopted after its default -- including tight fiscal policy -- are hardly antithetical to the IMF. The Times article noted one area where Argentina has disregarded the IMF’s advice: it has achieved its fiscal surplus in part by taxing exports, an IMF no-no. Over time, Argentina will want to cut its export tax, but I think the IMF has been a bit too doctrinaire here. Even with the export tax, Argentine exporters are far better off than they were with the overvalued exchange rate peso, and the IMF never objected to the currency board. Coverting dollar debt to peso debt provided exporters with a huge subsidy back in early 2002: agricultural debts taken out to finance the planting were "pesified" before the harvest, generating a huge windfall gain for some. The state giveth, the state taketh away. The Times could have added another big point of disagreement between the IMF and Argentina: Argentina’s use of its reserves to stabilize its exchange rate, post devaluation. Here too, I think the IMF was a bit too doctrinaire. The IMF let Argentina use a ton of its reserves to defend a massively overvalued exchange rate in 2001 (net reserves fell by $20 billion), but objected to the use of $3 billion or so of Argentina’s reserves in 2002 to try to prevent an already weak peso from falling further. Using a much smaller amount of reserves to try to prevent an already depreciated exchange rate from over shooting always struck me as a more sensible use of IMF resources than defending an overvalued exchange rate. The Times did note that Argentina put a lot lower priority on reaching agreement with its external creditors than other emerging economies, and no doubt a lower priority on concluding its debt restructuring than the IMF would have liked. However, the slow pace of Argentina’s external debt restrucutring is probably not the central component of Argentina’s post-default debt strategy. The key decision that Argentina made was not to postpone doing an external debt deal, but rather to "solve" its domestic debt problems once and for all by "pesifying" its debt (converting dollar debt to peso debt by decree, and thereby avoiding a big increase in the real debt burden). It then paid its domestic, pesified government debts while not paying its external bonds. Argentina decided that domestic financial stabilization was more important than trying to reestablish access to international markets. That is hardly a surprise. What is more surprising is that Argentina’s strategy suceeded: continued default on its external bonds did not prevent Argentina from stabilizing its domestic financial system. The pros and cons of pesification are too complex a topic for a simple blog post. It is well worth a whole book! The IMF has been willing to look carefully at the mistakes it made prior to Argentina’s default; it so far has not really tried to draw lessons from Argentina’s post default restructuring strategy ... even if Argentina succeeds at restructuring its bonds in early 2005, that probably will remain too hot a topic for the IMF to handle.

Yields on Latin American bonds have not been this low for a long time. It is hard to believe that Brazil’s 20 year dollar bond trades at a yield of only 8%, and most long-term Brazilian bonds are in the 8-9% range. Brazil’s economy is growing strongly this year, but its gross debt is still quite large.The broad rally in Latin bonds means the cash flow that Argentina put on the table in the summer is now judged to be worth a lot more by the market than it was some time ago. That is good for Argentina, and increases the chances Argentina will put its default behind it, and complete the biggest restructuring of emerging market bonds ever. The gap between Argentina’s offer and the market price has closed -- even though the actual amounts Argentina is offering to pay have not changed much since the summer. JP Morgan reports that the implied discount rate (yield) on Argentina’s new bonds is around 10.25%, 150 basis points (1.5%) above the yield on a comparable Brazilian bond. Back in the summer, the expected discount rate was closer to 12%. A warning: this post is not only long but not about the dollar or the US. At least in theory, I know more about sovereign debt restructuring than I do about currency markets ... so I want to work in a bit more emerging market commentary into the blog, but no doubt this post will not be of interest to many. My advice to Argentina is simple. Do the deal now, and if you cannot do it now, do it as soon as you can, even if it costs a bit more -- not because it is good for bond investors, but because it is good for Argentina. Back in 2001, before its default, Argentina promised investors a yield of over 15% or so to convince them to defer payments. That was a stupid deal -- Argentina had too much debt, and could not afford to pay such a high rate to defer payments. Now, after its default, investors seem willing to discount Argentina’s future cash flows at a rate of close to 10%. In a debt exchange, a country effectively sells new debt to retire its old debt, and right now is a good time for any emerging economy, even one if default, to be selling debt. More unsolicited advice for Argentina: don’t be penny wise and pound foolish. You have cash on hand right now, cash that could be used to provide that little extra something that could generate a high level of participation in the exchange. There is a sense in the market that the rally in emerging market bonds (and thus the value of Argentina’s existing offer) has reduced the prospects that Argentina will sweeten its offer. Maybe. But I think Argentina’s interest -- properly defined, though perhaps not as defined by Argentina’s president -- is still to put a bit more on the table at the last minute. An offer that clearly is a bit above the bonds have traded for the past year or so (@ 30 cents on the dollar) might generate much higher than expected participation, and save Argentina legal expenses down the road (Sorry, Cleary). President Kirchner can still take credit for negotiating hard, for getting substantial relief for Argentina and for timing the market almost perfectly. Argentina won big by waiting until now to do a deal. Kirchner should be able to make that case domestically -- he should not take much political heat if he improves the deal at the margins. Argentina’s sound fiscal policies deserve some of the credit for Argentina’s potential low exit yields. "Populist" Kirchner does not sweet talk the international bond market, but he has delivered fiscal results that -- after an exchange -- should allow Argentina to make real payments on its new bonds. Argentina refused a primary surplus of more than 3% in negotiations with the IMF, and then went out and ran a primary surplus that looks to be more than 5% of GDP. Former President Menem knew how to say what the bond market wanted to hear, but Menem tended to issue new bonds to pay the interest on Argentina’s existing bonds, even in good times. Rhetoric matters, but so do results -- and Kirchner’s fiscal record to date has been stellar, by Argentine standards. So far, Kirchner has made payments on Argentina’s performing debt out of Argentina’s fiscal surplus. That does not do bondholders any good if Argentina is not paying them, but that changes the moment payments start. An exchange won’t eliminate the need for sound fiscal policies. One features of recent sovereign defaults -- in Russia as well as Argentina -- is that fiscal policy tends to be a lot better after the default than before it. For all the talk of "market discipline," the discipline that comes from not having access to the market seems to be a bit stronger. Two other points. First, a deal that promises bondholders too much is not obviously in the interest of Argentina’s bondholders, at least not in their longer term interest. Bond holders can win, obviously, if Argentina promises to pay a lot over time. But if the market discounts that promise to pay at a high rate, the cash flow in the out years does not necessarily add a lot to the bond’s present value, which is what the market cares about. Bondholders can also win over time if Argentina makes promises to pay a smaller amount, and the market concludes that promise is credible and so the bond should trade a low discount. That is what happened in Russia: falling spreads on Russia’s long bond (now around 300 bp above Treasuries) have driven its price way, way up since Russia’s 2000 restructuring. If you promise too much, that kind of rally is not guaranteed: Ecuador resumed payments after its default in 2000 and the global environment has been kind to all oil exporter, but the cash flow on Ecuador’s bonds currently is discounted at a rate of over 11% (using early December data). Ecuador’s bonds likely will trade at a higher spread than Argentina’s bonds from the moment Argentina’s bonds are issued. Why? Because of Ecuador’s current politics, no doubt, but also because paying a coupon of around 10% on its roughly $4 billion in international bonds is not clearly in Ecuador’s political and economic interest should oil prices fall. That leaves Ecuador’s bondholders in a fundamentally precarious position. $400 million is about 1.3% of Ecuador’s GDP -- a substantial net transfer. The European Union’s budget for internal European transfers is of equal size. Ecuador can afford that kind of payment when oil is high, but market righly seems to doubt Ecuador’s ability and willingness to make that sort of net transfer should oil fall sharply/ Ecuador’s economy start to shrink. Second, Argentina’s debt to GDP ratio will still be close to 80% even if it secures a deal on its proposed terms. Interest payments on its external debt are modest initially, so Argentina just might be able to grow out of its debt and break free from its cycle of serial default (What Ken Rogoff has called debt intolerance). To do so, Argentina will have to maintain its current sound fiscal policies even as growth slows. Think Russia after 1999. It will also need to rebuild its domestic banking system on stronger foundations. The local banks currently hold lots of government debt that only pays a 2% real rate. That only works so long as local deposit rates are kept extremely low. But US rates are likely to rise, and the Argentina’s central bank won’t be able to fight peso appreciation forever -- so domestic Argentine rates are likely to rise too. Argentines are willing to accept low peso rates in part because they expect the peso to appreciate over time. Argentina -- and its international bondholders -- should expect that Argentina will have to pay more on its domestic debt over time. That is one important reason why Argentina truely cannot afford to pay as much as some bondholders have been seeking.

That does not necessarily mean the Turkish lira is cheap. Right now, given Turkey’s almost US scale current account deficit (close to 5% of GDP), the lira probably is a bit overvalued. Turkey is going to exchange a million old lira for one new lira in January. That will make working on Turkey a bit easier -- no more lira quadrillions -- but lopping a bunch of zeros off both the currency and off local prices is not going to make any one rich (apart from a few scam artists), nor will it change the lira’s external value. The same is true in Iraq: One dollar currently buys 1460 Iraqi dinar, but that does not necessarily mean the dinar is cheap. This article is not going to make me popular in some quarters. It seems that there are some folks selling dinar to the US retail market, though there not as many who are also willing to buy. The sales pitch for dinar often goes like "if each dinar were only worth one cent" ... you would make a killing. That, alas, is not going to happen. End the war, and Iraq’s economy should be bigger than the $20 or $25 billion it is now. So the dinar might (and emphasis should be placed on the might) do something like double in value if (a big if) all goes well in Iraq over some time frame. It also might fall if things go poorly. But Iraq is going to remain a relatively poor country for some time. The dinar is not going to go up by a factor of ten, let alone the factor of fifteen needed for one dinar to buy one cent. That would be like the euro appreciating so that one euro bought ten dollars, or the yen appreciating so that ten yen bought one dollar. Like Martin Wolf, I think the dollar has further to fall, but even I think that kind of change is just not going to happen. Make no mistake, the big brokers selling dinar are making a profit no matter what. The central bank was selling dinar this morning for 1460, so a million dinar cost about $685 in Baghdad. A broker is offering a million dinar for $790 over the internet. Getting the dinar out of Iraq probably takes a bit of effort -- the broker is offering a real service -- but that is still a nice markup ... Buying dinar is one way of diversifying out of the US dollar, but anyone considering making an interest free loan to the Iraqi government (that’s what buying dinars as an investment implies) ought to understand the risks. The dinar is not exactly a candidate to be the world’s next reserve currency.1) If you are buying dinars, you are betting on real appreciation through nominal appreciation of the currency -- that is to say betting that the way the purchasing power of Iraqis will increase is through a rise in the dinar’s value. If the currency appreciates in nominal terms from 1460 dinars to the dollar to say 1000 dinars to the dollar, an Iraqi that makes say 10,000 dinar a day would be able to purchase $10 rather than @$7 of the world’s goods. 2) You lose if the nominal exchange rate goes down, obviously, for whatever reason -- civil war, lower oil prices, etc. You also lose -- or at least don’t win -- if Iraq’s dinar stays stable in nominal terms but the currency appreciates in real terms because of inflation in Iraq. In that case, our Iraqi’s salary would go up to 15,000 dinar a day rather than 10,000 dinar, but the exchange rate would stay around 1,500 dinar per dollar. The Iraqi could then buy $10 of the world’s goods even though the exchange rate stays constant. Iraqi citizens are richer, those holding its currency abroad are not. This is not an entirely unrealistic scenario. 3) Iraq’s government has fairly strong incentives to keep the currency stable -- it is one of the few signs of political and economic stability the government can point to. It also has some incentive to resist letting the Iraqi dinar rise in real terms. A stronger currency makes imports cheaper and any Iraqi production (to the extent there is Iraqi production) relatively more expensive. Not exactly the best way to solve Iraq’s unemployment problem. The Iraqi government, one presumes, does not want Iraqi wheat production, for example, to be uncompetitive with imported wheat. 4) Oil alone does not make betting on Iraq’s currency a slam dunk, to paraphrase George Tenet. With production @ 2.5 mbd (November seems to have been a bit lower) and with oil at $50, Iraq is getting a fairly solid revenue stream -- nearly $2 billion a month -- from its oil right now. Even if the security situation stabilizes and, over time, Iraq can bring more oil production on line, it may do so in a less robust world economy with lower oil prices. So Iraq may make less money from selling a larger amount of oil than it does now ...