Battle hots up to curb 'vulture funds'

The issue of sovereign debt has once again come to the fore as Argentina battles a couple of hedge funds which bought up some of its debts and seek to extract their pound of flesh. Martin Khor explains how this fight has now culminated in an historic UN resolution designed to obviate such crises by moving towards the establishment of an international debt restructuring mechanism.

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EXTERNAL debt is rearing its ugly head again. Many developing countries are facing reduced export earnings and foreign reserves.

No country would like to have to seek the help of the International Monetary Fund (IMF) to avoid default. That could lead to years of austerity and high unemployment, and at the end of it, the debt stock might even get worse. Low growth, recession, and social and political turmoil are probable. This has been experienced by many African and Latin American countries in the past, and by several European countries presently.

When no solution is found, some countries then restructure their debts. Since there is no international system for an orderly debt workout, the country would have to take its own initiative. The results are usually messy, as it faces a loss of market reputation and the creditors' anger. But the country swallows the pill rather than have more turmoil at home.

Such was the experience of Argentina, whose public debt reached 166% of GDP in 2002.  After many years of decline and political instability, Argentina defaulted in 2001. Argentina then arranged for two debt swaps in 2005 and 2010, thus restructuring its debt with 93% of its creditors, who agreed to receive about a third of the original debt value.

But 7% of creditors, known as 'holdouts', did not agree to the restructuring. A few influential hedge funds (comprising only 1% of creditors) which had bought some of the debt very cheaply on the secondary market sought a court order in New York (where the original loans had been contracted)  to be paid in full.

There are several such funds, now popularly termed 'vulture funds', that specialise in buying distressed debt at low prices (say, 10% of the original loan value) and then insisting through the courts on being paid in full with interest. Like vultures, they circle overhead and swoop to make a meal of the dead or dying bodies. Only in this case the 'bodies' are countries and they are asked to squeeze their shrivelled economies further to pay the vulture funds.

The US judiciary, after a long process that went to the Supreme Court, decided a few months ago that the holdout hedge funds that took up the case concerning the Argentine debt should indeed be paid in full and with interest. 

Further, it decreed that the 93% of creditors who had already agreed to be paid at a big discount are now not allowed to be paid, unless the vulture funds are paid in full at the same time. The New York judge used the principle of pari passu (that all creditors should be treated the same) in reaching the decision.

Argentina had already arranged with a bank in New York to pay out interest to the 93% a few weeks ago, but the bank refused to do so, due to the court order.

The vulture funds want their pound of flesh. The main fund, NML Capital, would make an estimated 1,600% profit. 

Argentina's President Cristina Kirchner refused to bow to these funds. If she did, the country might have to also repay all the creditors the full value, which is $120 billion, and that is impossible to do.

This incredible turn of events has caused outrage among many public interest groups and anger among developing countries' governments. The South Summit of the G77 developing-country grouping in May in Bolivia criticised the vulture funds and called for a proper global debt restructuring mechanism.

Finance ministries of developed countries have been concerned as well as many are also affected. Greece went through debt restructuring, in which private creditors agreed to take a loss, a few years ago. 

Accepting the US court decision as the new template would make it quite impossible for any country to restructure its debts, since the now emboldened vulture funds would pounce and block it.

Influential Financial Times commentator Martin Wolf has supported Argentina in its battle with the vulture funds, even saying that it is unfair to the real vultures to name the holdouts as such since at least the real vultures perform a valuable task!

At the end of August, the Swiss-based International Capital Market Association, a group of bankers and investors, issued new standards aimed at reducing the ability of holdout investors to undermine debt restructuring. 

On 9 September, the G77 succeeded in promoting a resolution at the United Nations General Assembly which recognised that a state's efforts to restructure debt should not be impeded by hedge funds that seek to profit from distressed debt.

The General Assembly, by a vote of 124 in favour, 11 against and 41 abstentions, also decided to set up a multilateral legal framework for sovereign debt restructuring by the end of its 69th session (around September 2015), to increase the stability of the international financial system.

An international debt restructuring mechanism will be a systemic solution, since countries with debt crises can have recourse to an international court or system and need not do a messy debt restructuring on its own.

There will now be an uphill battle to get the resolution implemented, since the United States, Germany and the United Kingdom (all key countries in global finance) were among those which objected. 

Another resolution, initiated by Argentina, was adopted by the UN Human Rights Council on 26 September, aimed at setting up legal frameworks to curtail vulture funds' activities and for sovereign debt restructuring.

One good thing is that the UN, which is a universal body in which developing countries have a greater say in decision-making, is now at the centre of the debt discussion. 

The negotiations ahead will be tough but well worth it since preventing and managing a debt crisis is now a priority for a growing number of countries.                                                

Martin Khor is Executive Director of the South Centre, an intergovernmental policy think-tank of developing countries, and former Director of the Third World Network. This article first appeared in The Star (Malaysia) (15 September 2014).

*Third World Resurgence No. 289, September 2014, pp 9-10