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Sovereign Default, Debt Restructuring, and Recovery Rates: Was the Argentinean “Haircut” Excessive?

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Abstract

I use data on 180 sovereign defaults to analyze what determines the recovery rate after a debt restructuring process. Why do creditors recover, in some cases, more than 90 %, while in other cases they recover less than 10 %? I find support for the Grossman and Van Huyk model of “excusable defaults”: countries that experience more severe negative shocks tend to have higher “haircuts” than countries that face less severe shocks. I discuss in detail debt restructuring episodes in Argentina, Chile, Uruguay and Greece. The results suggest that the haircut imposed by Argentina in its 2005 restructuring (75 %) was “excessively high.” The other episodes’ haircuts are consistent with the model.

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Notes

  1. See, for example, the discussion in Edwards (2010).

  2. The basic data were assembled by Cruces and Trebesch (2013). This is the largest data set on restructurings and haircuts. Benjamin and Wright (2009), for example, used a data set with 90 episodes in their analysis on restructuring delays. For an even more comprehensive list of sovereign defaults, see Beers and Nadeau (2014). This data set, however, dos not have data on recovery rates.

  3. See the discussion in Sturzenegger and Zettelmeyer (2006) on alternative ways of measuring losses.

  4. Twelve of the 180 restructurings included a warrant linked to either the terms of trade or GDP: Honduras 1989, Costa Rica 1990, Mexico 1990, Venezuela 1990, Nigeria 1991, Uruguay 1991, Bolivia 1993, Bulgaria 1994, Ecuador 1995, Bosnia 1997 Cote d’Ivoire 1998, and Argentina 2005.

  5. See Miyajima (2006).

  6. See, for example, Costa, Chamon et al. (2008), Miyajima (2006), HSBC’s “EM Portfolio Strategy” (July 21, 2005), and Sandleris and Wright (2013).

  7. To put things into perspective, analyses of the Greek sovereign restructuring of 2012 based on the same methodology indicate that the aggregate haircut (across all restructured bonds) was of the order of 60 %. See Zettelmeyer et al. (2013).

  8. The Jarque-Bera tests are 13.3 and 7.8 respectively, rejecting the hypothesis of normality at a very high significance level.

  9. These four countries, plus Haiti, form the “poorest five” group in Latin America and the Caribbean.

  10. For details on the Argentine crisis of 2001–02 see, for example, Edwards (2002), Blustein (2005), and IMF (2004). Most of these shocks were temporary. See Section 4 of this paper for a discussion on the magnitude of these shocks.

  11. See, Blustein (2005).

  12. See IMF (2004) for a detailed timeline of earlier events. See, Sturzenegger and Zettelmeyer (2006) for details on the negotiations.

  13. These bonds were available in a number of currencies — US Dollars, Euros, Yen, and Argentine pesos indexed to the local consumer price index (CPI). The initial coupon was very low, but would increase gradually through time (from 1.33 to 5.25 %). Amortization was expected to begin in 2029.

  14. These securities were also available in US Dollars, Euros, Yen, and Argentine pesos indexed to the local consumer price index (CPI). They had 30 years maturity and amortization would begin in 2024. The exchange would take place at 33.7 % of the original face value. This fact led the popular press to report that investors’ haircut amounted to 66.3 %. This computation, however, is based in the incorrect methodology for the reasons discussed in the text.

  15. These securities had a 42 year maturity, were exchanged for 69.6 % of the original face value and had a coupon rate of 3.31 % that was capitalized during the first ten years. Amortization was to begin in 2036. These Quasi Par bonds were only available in (inflation adjusted) pesos.

  16. The conditions for this payment to kick were: growth in the preceding year had to exceed 3 % and total payments could not exceed 48 % of the original value of each bond. See, Sturzenegger and Zettelmeyer (2006). According to Cruces and Trebesch (2013), investment banks were not sure how to value this GDP kicker. In November 2005, six months after the exchange had taken place, the GDP-linked warrants were to become detachable.

  17. Cruces and Trebesch (2013).

  18. A number of news media stories covered, in detail, the Supreme Court decision and the implications of the lower court ruling. See, for example, http://www.bloomberg.com/news/2014-06-16/argentina-rejected-by-u-s-high-court-on-defaulted-bonds.html

  19. The government of Argentina claimed that it had not defaulted in late July 2014. The reason, according to Argentina, was that it had made a deposit covering the July 2014 coupon payment to new bondholders in the Bank of New York. Judge Thomas Griesa, however, forbade the bank from paying these investors if Argentina was unwilling to pay the holders of old bonds that had brought the case to court. This ruling has generated significant discussion among economists regarding the future of sovereign restructurings.

  20. On the “excusable default” model see, for example, the discussion in Yue (2010). See, also, Alfaro and Kanczuk (2005). For an early study on spreads in sovereign bonds and loans, see Edwards (1986).

  21. Restructurings may be delayed and take some time, but they eventually occur. See Benjamin and Wright (2009) for an analysis on delays.

  22. A number of historical analyses, including Reinhart and Rogoff (2009), have concluded that three of the shocks considered here have usually been present during major debt crises. A six year window covers, in the vast majority of cases, the default itself and the restructuring. For 108 episodes with data the mean time elapsed between default and restructurings was 6.2 years. Reinhart and Rogoff (2009) don’t include wars and coups in their analysis; they do include banking crises.

  23. More specifically, a devaluation crisis is defined as an abrupt increase in the value of foreign currency (the U.S. dollar) of at least 20 % that takes place after a period of relative exchange rate stability That is, large annual devaluations stemming from the adoption of a crawling peg or other type of managed currency regime are not considered to be a crisis.

  24. The cutoff point is a GDP per capita in PPP dollars of 4000 in 2010. Most of these nations, however, have a GDP per capita below 2000 PPP dollars. Many of these countries — but not all of them — eventually became eligible for the IMF and World Bank’s HIPC debt relief program.

  25. These variables were dated three months prior to the restructuring.

  26. Jarque-Bera tests on the residuals from OLS estimates reject the null of homoskedastic errors. The same test indicates that the use of White-corrected estimates solve the problem.

  27. Notice that in equations (3.1)–(3.2) there are 153 observations. The reason for this for some episodes there are no data for all the covariates. This is particularly so during the early years. See Cruces and Trebesch (2013) for a discussion on data quality and reliability.

  28. See, Chamon et al. (2008), and Sandleris and Wright (2013).

  29. See, for example, Miyajima (2006).

  30. The data are from Dreher (2006) and from the IMF website. The data on wars and civil conflicts are from the Integrated Network for Social Conflict Research. The data on natural disasters are from the Center for Research on Epidemiology and Disasters. The data on coups and coups attempts are from the Peace Research Institute of Oslo. For further details on data sources, see Appendix B.

  31. In some of these tests the Argentina’s 2005 residuals were exactly on the outlier bands.

  32. The tests in Fig. 2 show some gaps, due to two facts: (1) Not every episode has data for all covariates; (2) the estimates in equation (5.5) refer to the 1980–2010 period.

  33. Argentina’s terms of trade have historically been quite volatile, and a 9 % decline is well within what is normal. Indeed, an analysis of Argentina’s recent past provides strong support for the notion that declines in terms of trade are common, cyclical and temporary. For example, in 1974, Argentina’s terms of trade deteriorated by 14 %, and in 1975 they dropped further by 11 %. In the next three years, however, the terms of trade improved by 23, 15 and 8 %, respectively. This terms-of-trade cycle repeated itself in the mid-1980s: in 1986, the price of Argentine exports relative to its imports declined by 21 %, and in 1987 they dropped by an additional 11 %. In each of the next three years they improved by 29, 8 and 10 %, respectively.

  34. The weighted average is from the four episodes when the equation corresponds to 1978–2010. It is for 1990 only when the estimate is restricted to 1988–2010.

  35. See Edwards and Edwards (1991) for details.

  36. In fact, Uruguay suffered more severe terms of trade shock than Argentina. It experienced a currency crisis, and a GDP collapse similar to that of Argentina. See Edwards (2010).

  37. At the time of this writing Greece is once again facing debt problems and there is talk of a new restructuring. For a discussion and some estimates see, for example, Philippon (2015). I thabks George Tavlas for helping me clarify this point.

  38. A simple version of this methodology may be described as follows: First, the analyst determines the country’s “capacity to make payments.” Say, interest payments should not exceed X% of GDP per year. Second, the debt to GDP ratio that is consistent with payments not exceeding X% of GDP is calculated. This is called the “sustainable” debt to GDP ratio. The “appropriate haircut” is then computed as the amount by which the current debt needs to be reduced in order to make the actual debt to GDP ratio equal to the “sustainable” ratio.

  39. See Aizenman and Lee (2007) for an analysis of the role of international reserves in debt crises. See, also, Reinhart and Rogoff (2010).

  40. Whether sovereigns can actually precommit is an open question. Indeed, in the absence of international bankruptcy courts (or equivalent institutions), it is not possible.

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Acknowledgments

* I thank Alvaro Felipe García and Jorge Bromberg for their assistance. Subsection 2.2 draws, partially, on a report prepared for White & Case LLP in September, 2012. As always, discussions with Ed Leamer have been very useful. I also thank participants at UCLA’s finance seminar for helpful discussion. I thank George Tavlas for his comments.

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  1. University of California, Los Angeles, Los Angeles, CA, USA

    Sebastian Edwards

  2. National Bureau of Economic Research, Cambridge, MA, USA

    Sebastian Edwards

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Appendices

Appendix A

1.1 Sovereign Borrowing and Excusable Default: A Conceptual Framework

In this Appendix I discuss the Grossman and Van Huyck (1989) model of sovereign borrowing and default, which provides the conceptual bases for the empirical analysis in this paper. In this model there is no money and, thus, currency crises are ruled out. There is a risk free security with a rate of return ρ, and loans are for one period. There are no capital controls. Sovereign borrowers can invest in a risk free technology, or can purchase the risk free security. Lenders, on the other hand, face a competitive market and are risk neutral.

Borrowers maximize the present value of consumption. Their objective function is:

$$ \Omega =U\left({c}_t\right)+{\displaystyle \sum_{i=1}^{\infty }}\frac{E\left(U\left({c}_{t+i}\right)\right)}{{\left(1+\delta \right)}^i} $$
(A.1)

Conventional notation is used. δ is the consumer’s discount rate, and E(…) is the expectations operator, conditional on all available information. Consumption is given by the sum of three elements:

$$ {c}_t=F\left({b}_{t-1}\right)+{z}_t-{s}_t. $$
(A.2)

Where F(b t − 1) is a function that captures the return from last period’s borrowing (b t − 1); z t is the stochastic component of income, and depends on the state of the world (see below for details); and s t is debt service in period t. It is assumed that s t  ≥ 0; that is, the borrower cannot buy insurance that will cover them if there is a very bad state of the world. Also, for simplicity, it is assumed that borrowing cannot be used for consumption; a relaxation of this assumption would not affect the results in a fundamental way. The F function has the following properties:

  • F ′ > (1 + ρ), and F ″ < 0, if b ≤ B.

  • F ′ = (1 + ρ), and F ″ = 0, if b > B.

That is. the return from investing in the local technology exceed the opportunity cost up to a point B; from that point on the marginal productivity of output is equal to the world risk free rate of return ρ.

The z t are drawn from a stationary probability distribution p(z), with mean \( \overline{z} \). The discreet z realizations range from a “good” state of the world Z to the worst possible state of the world ξ. Naturally, p(Z) ≫ p(ξ).

In equilibrium, creditors’ expected income across all states of the world — each of them with a probability p(z) — is equal to the risk-free return. Assuming that an amount b t is lent in period t, this implies:

$$ {\displaystyle \sum }p(z)\left\{E\ \left[{S}_{t+1}\left({z}_{t+1}\right)\right]\right\}=\left(1 + \rho \right){b}_t $$
(A.3)

E[s t + 1(z t + 1)] plays a key role in the model. It is the creditor’s expectation of the sovereign’s debt servicing decision for period t + 1. It is assumed that in forming this expectation creditors know borrowers preferences and utility function — that is they know Ω —, and that they know the sovereign’s payment plans into the future. Thus, lenders know sovereign’s debt servicing plan R t  ( z t + 1 ), which is generally contingent on the state of the world. The actual solution of the model will depend on this R t ( z t + 1) plan. Below I consider three cases for R t (z t + 1).

To summarize, a utility maximizing sovereign will have to make three simultaneous decisions: how much to borrow today (b t ), how much debt to service today (s t ), and what type of plan to adopt for future debt service payments. This payments plan R t is contingent on the states of the world z t + 1. This payment decision will determine the nature of the equilibrium. In the rest of this appendix I consider three cases:

Case1: Precommitment

Assume that the sovereign can credibly precommit to follow a payment strategy that is strictly depending on the realization of the state of the world z t + 1. This plan is denoted as \( {\tilde{R}}_t\left({z}_{t+1}\right) \), which is equal to ∑p(z){E [S t + 1(z t + 1)]}. In this case there will be full risk shifting from the sovereign to the lender. Both the amount borrowed and the payment plan will be time invariant:

$$ \tilde{b}= \max \left(B,\ \frac{\overline{z}-\xi }{1+\rho}\right), $$
(A.4)
$$ \tilde{R}\left({z}_{T+1}\right)={z}_{t+1}-\overline{z}+\left(1+\rho \right)\tilde{b}. $$
(A.5)

Actual debt service will depend on the sign of \( \left({z}_{t+1}-\overline{z}\right) \). In the bad state of world \( \left(\xi -\overline{z}\right)<0 \), and payment will be less than debt plus interest. This is the “excusable default” solution. In this case, the haircut will depend on the severity of the negative shocks, and will be equal to \( \left(\ \overline{z}-\xi \right) \), the difference between the mean of the stochastic component of income and the bad state of the world realization.

Case 2: Repudiation

Assume now that instead of precommitting, the sovereign maximizes utility without any concern regarding its reputation or ability to borrow in the future.Footnote 40 The simple and myopic maximization of (A.1) implies, for all states of the world, that s t  = 0. If the creditor anticipates this plan, then b t  = 0, for all states of the world. This is a suboptimal outcome with no borrowing; if borrowing does happen, the debt would be fully repudiated.

Case 3: Reputation

Assume, finally, that although the sovereign cannot strictly precommit, it does care about its reputation. The creditor, in turn, takes into account the borrower’s past behavior to elucidate its payment intentions in the future; creditors have rational expectations, and use information about the past to form its expectations about the future. In this case, it never pays for the borrower to mislead the creditor; that is, in every period t + 1, the sovereign validates the expectations that the creditor formed about the contingent payment plan R ∗(z t + 1). This plan, then, is the best plan within the class of incentive compatible payment plans. Under most values of δ, and sovereign’s degree of risk aversion (curvature of the ultilty function), the reputational equilibrium implies an amount of borrowing lower than in the precommittment case, and incomplete risk shifting from the borrower to the lender. The payment function R ∗(z t + 1) will be state contingent, and under bad states of the world (when z t + 1 = ξ) debt service will fall short of the debt plus interest. That is, in a bad state of the world there is an “excusable” partial default. The magnitude of the default, or haircut, will depend on \( \left(\ \overline{z}-\xi \right). \) That is, the haircut will be larger, the more severe are the negative shocks that affect the sovereign.

Appendix B

2.1 Data Sources

Wars and civil conflicts: Integrated Network for Social Conflict Research (http://www.systemicpeace.org/inscr/inscr.htm).

Coups and coups attempts: Peace Research Institute of Oslo (PRIO), Norway (http://www.prio.no/).

Output collapse: Constructed from raw data form the World Development Indicators.

Currency Crises: Constructed from raw data form the World Development Indicators.

Poor: Constructed from data from the World Development Indicators.

Recessions: Constructed from data on recessions from the National Bureau of Economic Research.

Ten year Treasury yield: Federal Reserve of St. Louis, FRED data base.

Haircuts: Basic data from Cruces and Trebesch (2013).

Characteristics of restructuring deals: Basic data from Cruces and Trebesch (2013).

Natural Disasters: Center for Research on the Epidemiology of Disasters (CRED) (http://www.emdat.be/database)

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Edwards, S. Sovereign Default, Debt Restructuring, and Recovery Rates: Was the Argentinean “Haircut” Excessive?. Open Econ Rev 26, 839–867 (2015). https://doi.org/10.1007/s11079-015-9350-3

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