Rodrigo Olivares-Caminal untangles the issues for pension funds that find themselves creditors of a sovereign in default

Recent sovereign debt crises such as Argentina, Iceland and Greece are useful to
comprehend the complexities and possible implications for a pension fund in the event of a sovereign default. Although some events are still unfolding, Argentina's is a clear historical case of debt mismanagement aggravated by external shocks and a lax fiscal policy. Iceland and Greece are two very alive, ongoing cases.

The case of Iceland involves the collapse of Kaupthing, Glitnir and Landsbanki, three internationally active Icelandic banks that were too big to fail and at the same time too big to be saved by Iceland's government. This led to a different type of banking crisis: one that developed in a currency crisis and escalated to a sovereign debt default crisis with severe international connotations. In Iceland's case, private financial institutions were bigger than the country's own economy.

Greece is the latest addition to recent sovereign debt crises. Greece is facing a 13% annual deficit and has a 75% debt-to-GDP ratio. It presents the potential for spillovers into other euro-zone members, and some additional difficulties in terms of sensitive political issues. The Greek situation has raised two main questions: (1) whether the European Union possesses the powers to rescue Greece despite the no-bail-out clause of the Treaty of Lisbon (articles 122 and 125); and (2) whether an International Monetary Fund (IMF) intervention is possible. What would happen if the IMF provided assistance to Greece and in exchange demanded a certain monetary policy or restructuring of external debt? Would that not conflict with ECB monetary policy?

The first question seems simpler: if there is political will it can be argued that the 2008-2009 financial crisis constitutes an ‘exceptional occurrence beyond control' despite any alleged political manipulation and book-cooking of the macroeconomic data. Although the second question seems more difficult, it ends up reducible to political will again: the IMF and the ECB can design a monetary policy that suits Greece's needs and which at the same time complies with the ECB policy toolkit.

As the Greek debt crisis rumbles on and Iceland is still trying to find a way out of its difficult situation it is worth considering the different roles of pension funds when a sovereign default occurs.

Although each sovereign debt crisis and its restructuring exercise is unique, certain similarities can be recognised. All sovereign crises are resolved by means of an exchange offer where an old, illiquid debt instrument in default is swapped for a new, liquid debt instrument with worse economic and financial terms. Sovereign debt restructuring has an important degree of complexity because it merges the perspectives of the debtor, creditors and international financial institutions.

The creditors of a sovereign may be divided into two large categories: official creditors (multilateral organisations and countries that extend bilateral loans); and private creditors. Private creditors, in turn, may be subdivided into institutional or sophisticated creditors (including pension funds); and retail or individual creditors. Under a sovereign debt restructuring, the exchange offer extends to private creditors.

Different creditors bring different perspectives to the restructuring. For example, the interests of a hedge fund, an investment bank and a pension fund are not the same. Pension funds will be among a group of creditors trying to find a solution - suing the sovereign or entering into a debt swap or restructuring arrangement, but with their own agenda.

In the Argentine case study, currency devaluation caused a domestic redistribution of wealth in the order of $30bn from savers' bank deposits and pension funds to private-sector debtors and provincial governments. Pension funds can suffer a loss upon a sovereign debt crisis.

Upon a debt crisis, the sovereign will try to regain access to the capital markets by facilitating a restructuring arrangement to all creditors. A redistribution of wealth can easily alienate pensioners not willing to participate in such arrangement, and so a pension fund could continue to be a creditor, but be instructed by its affiliates not to participate in restructuring arrangement - becoming a so-called ‘holdout creditor'.

Following this line of thinking, it should be recalled that the Argentine government offered more favourable terms (in the form of accounting benefits) to Argentine pension funds in order to increase their degree of participation in the exchange offer. The rationale behind improving the net present value of the exchange offer for pension funds was that they held approximately 20% of the total outstanding defaulted debt. However, as beneficial as this seems, this kind of privileged position vis-à-vis other creditors might not only affect the pari passu clause (a common clause in debt instruments) but also (1) the non-discriminatory treatment of foreign nationals and foreign financial institutions (that is, the principle of ‘national treatment') under WTO-GATS principles (Article XVII of the General Agreement on Trade in Services); and (2) the fair and equitable standard under international investment laws, due to the suppression of holdout rights and the national treatment and most-favoured-nation clauses in bilateral investment treaties. This clearly shows that there might be a special interest in aligning the interests of all pension funds to participate in an exchange offer and reduce the number of holdout creditors. However, this can be challenged at a court of law.

To fully comprehend the spectrum of possibilities for pension funds and their pensioners, it is important to analyse the role played by vulture funds - which can also be among holdouts. Vulture funds play an eminent role in international financial markets, purchasing defaulted debt to satisfy the seller's liquidity requirements.

Needless to say, in order to take this risk, the debt is purchased at a large discount to par. The vulture fund bets on recovering the debt's par value through a legal action, therefore not only covering collection expenses but also obtaining an additional gain, which is its source of income. For example, a vulture fund that purchased defaulted bonds of the Republic of Argentina by mid 2002 - when the bonds traded at 0.2% or less of par and at the time of the exchange selected the peso-denominated bonds at a price of 35-37 cents, would have obtained an annual yield of 25%. This is the reason why many Italian pensioners - who held large quantities of Argentine debt through their pension funds and, upon default, considered that they would not recover their investment - traded their debt to vulture funds, which made a significant gain.

Finally, the nightmare can become worse. In the case of Argentina, the government decided in 2008 to nationalise nearly $30bn in private pension funds with the excuse of protecting pensioners from the ongoing global financial crisis. The real reason was to increase government resources to face the fiscal crisis of 2009.

In summary, a sovereign debt crisis can considerably undermine the future prospects of a pension fund. Therefore, it is important to carefully consider the complexities, magnitude and possible implications of a sovereign debt crisis.

Rodrigo Olivares-Caminal is sovereign debt expert with the UN Conference on Trade and Development (UNCTAD) and assistant professor at the University of Warwick. His book, Legal Aspects of Sovereign Debt Restructuring, is published by Sweet & Maxwell