3 November 2016 by Renaud Vivien , Daniel Munevar
CC - Flickr - Jaume Escofet - Mural Caracas
After the prolonged legal battle of Argentina and the ongoing negotiations in Puerto Rico with vulture funds
Vulture fund Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors. over both countries debts, a new clash on the sovereign debt Sovereign debt Government debts or debts guaranteed by the government. of a Latin American country looms large in the horizon. That of Venezuela.
Despite having the largest oil reserves in the world, the drastic reduction in oil prices and national production that took place over the last two years have wrecked havoc on the Venezuelan economy: GDP
Gross Domestic Product Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another. has steadily contracted since 2014, exports collapsed by 50% in 2015 while foreign reserves have fallen to a 12 year low of USD 12 billion. |1| Given the large foreign funding needs of the country for 2016-2018, which include at least USD 27.2 billion for debt repayments |2| and an additional USD 16.6 billion to cover the commercial transactions of the country |3|, it remains unclear how the country will be able to close this gap. In a context in which access to external funding is effectively non-existent, a default over the country’s foreign debt is becoming an increasingly likely event. In theory, a default would provide the resources and time required for an economic recovery. However, as it was the case for Argentina, the legal structure of Venezuela’s debt is vulnerable to the actions by vulture funds Vulture funds
Vulture fund Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors. . These are in a position to impose significant costs on the country limiting the short-term relief provided by unilateral measures aimed at dealing the country’s debt. Thus, what is Venezuela to do?
In order to understand the trade offs facing the country is necessary to take a look at the economic and legal structure of its external debt. The first part of this article provides an overview of the recent evolution of the country’s debt. A second part, discusses the legal mechanisms available to vulture funds to put pressure over Venezuela in the event of default. The third section discusses options available to the country.
Venezuela’s’ foreign debt
The starting point of any assessment regarding Venezuela’s debt has to do with the quality of available data. Factors such as extremely high inflation
The cumulated rise of prices as a whole (e.g. a rise in the price of petroleum, eventually leading to a rise in salaries, then to the rise of other prices, etc.). Inflation implies a fall in the value of money since, as time goes by, larger sums are required to purchase particular items. This is the reason why corporate-driven policies seek to keep inflation down.
, capital controls and different exchange rates make it difficult to assess with certainty the economic costs associated to foreign debt, as well as its sustainability. With this caveat in mind, a look at the recent evolution of the country’s debt shows a large increase in the aftermath of the global financial crisis. Between 2008 and 2015, Venezuela’s public debt increased from USD 50.9 billion to USD 120.2 billion. |4| This figure includes debts owed by the central government, debts owed by PDVSA as well as bilateral loans from China. In this regard, it is important to highlight that even though PDVSA debts are not covered by a government guarantee, and as such they are technically not a form of public debt, for practical purposes they are accounted within the overall liability structure of the public sector of Venezuela given the interdependence between both entities. |5| With this caveat in mind, in 2015 central government accounted for 46% of the total debt, PDVSA (the state owned oil company) an additional 35% while the loans from China represent the remaining 19%. |6| Out of this figures, it is estimated that USD 68 billion correspond to bonds denominated in foreign currency by either the government or PDVSA. |7| Furthermore, to complete the picture, the public foreign debt of the country represents 83% of the total, which includes debt denominated in domestic currency.
In terms of the burden associated to the debt, the expectations of default have caused interest rates
When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…
The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation. to skyrocket to around 30%. As a result, interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. payments are creating a self-reinforcing downward spiral by putting additional pressure on the government finances. In practical terms this means that for the 2016-2018 Venezuela is facing total interest payments of USD 15.4, and principal repayments of USD 8.2 billion for PDVSA and USD 3.6 billion for the central government. |8| Furthermore, a significant share Share A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings. of these payments will take place over the next months. An estimated USD 5.2 billion is due to be repaid between October and November of this year, with an additional USD 2.3 billion coming due in February of 2017. As the country faces widespread scarcity of basic imported goods, such as food and medicines, these payments represent a significant opportunity cost for Venezuela. In relative terms they are equivalent to nearly 7 months of imports or 61% of its foreign reserves. |9| On the face of it, and just looking at the economic fundamentals of the country, it would make sense to default and restructure its debts. However, a look at the legal implications of such course of action gives pause to that thought.
A vulture’s game
As the recent experiences of Argentina and Greece show, legal control over sovereign bonds represent a crucial tool to protect a country in the event of default. In the current context, the problem with Venezuela is precisely that it has long renounced to it. Practically all of its sovereign debt
Government debts or debts guaranteed by the government.
, as well as that of PDVSA, has been issued under New York law. Thus, in the event of a default, foreign bondholders can refuse to participate in a debt restructuring process and instead seek repayment in full of bonds that are currently trading
trading Buying and selling of financial instruments such as shares, futures, derivatives, options, and warrants conducted in the hope of making a short-term profit. for as little as 50 cents on the dollar. |10| As the Argentinian case has shown, vulture funds can rely on sympathetic US courts to enforce those claims leaving a country like Venezuela with practically no recourse to protect its sovereign interests. Even worse, the expectation of holdouts in a potential debt restructuring creates incentives for other investors to refuse to participate in it. This increases the overall costs and economic dislocations of the process: why accept a fair offer for settlement for a given percentage of the original claim when other investors stand to be repaid in full?
The complexity of the Venezuelan case is also compounded by the close interdependency, in both economic and legal terms, of the government and PDVSA as well as the specifics of the bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. contracts of both entities. In the first case, in the event of a default some analysts argue that it would be extremely difficult to disentangle Venezuela´s and PDVSA´s liabilities Liabilities The part of the balance-sheet that comprises the resources available to a company (equity provided by the partners, provisions for risks and charges, debts). , even though there is no sovereign guarantee on the bonds issued by the oil company. We can also be worried that if Venezuela were to default on its sovereign debt, foreign creditors would react by trying to seize the country´s assets located abroad. This would put the extensive network of refineries, tankers and oil shipments of PDVSA at direct risk. Given the large reliance of the government of Venezuela on the foreign currency earnings of its oil company, the potential disruptions on its commercial operations would further cripple the economy of the country. It is estimated that the losses derived from such a scenario could reach up to USD 5.7 billions per year, more than enough to wipe any potential gains from a restructuring. |11| However, its important to note that in this scenario, Venezuela could claim State immunity in order to protect its oil industry. Indeed in the litigation between DRC and the vulture fund FG Hemisphere, the UK Privy Council Judicial Committee rejected in 2012 the request of Hemisphere that was seeking assets held in Jersey which are owed to DRC’s state mining company, Gecamines. The vulture fund claimed Gecamines was an ’organ of the state’ and so responsible for debts owed by Democratic Republic of Congo. However, the Privy Council found that whilst Gecamines is a state-owned company, it is not responsible for the Congolese government’s debts.
In the second case, the uneven distribution of Collective Action Clauses (CACs) among the different debt instruments of both the government and PDVSA has the potential to significantly increase the costs and complexity of a restructuring. In this regard, the CACs allow a country to restructure its debts by managing to reach an agreement with a controlling majority of bondholders. This reduces coordination costs between debtors and creditors and closes the door to potential holdouts by forcing them to accept the terms agreed with the controlling majority. In the case of Venezuela, its government debt Government debt The total outstanding debt of the State, local authorities, publicly owned companies and organs of social security. can be broadly distributed in 3 categories. Two sets of bonds, due in 2018 and 2027 contain no CACs and would require unanimous creditor agreement to restructure. |12| The difficulty in restructuring these two sets of bonds makes them the perfect target for vulture funds aiming to take Venezuela to court. Another two sets of bonds, due in 2018 and 2034 contain CACs that require an agreement with 85% of the bondholders. The remaining debt of the country also contains CACs, but in these cases with a 75% bondholder threshold. All of these bonds also contain cross default clauses that preclude the option of selective default: a default in one bond series would trigger the acceleration of payment and ensuing default of the rest of the bonds. |13| In the case of PDVSA the situation is even worse as by design none of its bonds contain CACs. |14|
In this difficult context, political measures should be taken as soon as possible by Venezuela, on the ground on international law. Indeed, even if there is not an international mechanism for an orderly sovereign debt restructuring, Venezuela could still use a legal argument based on the protection of fundamental rights. These include the right for any State“ in the exercise of its discretion, to design its macroeconomic policy, including restructuring its sovereign debt, which should not be frustrated or impeded by any abusive measures,” in line with the UN Resolution of 10 September 2015. |15| Furthermore, the rise of human rights, both in treaty and customary form, clearly gives rise to a duty to construe debt arrangements from the lens of individual freedoms and corresponding state obligations. Where the repayment of a debt jeopardises human lives or leads to unnecessary deaths, malnourishment, the spread of diseases, widespread poverty, lack of access to essential services, including education and health, or the infringement of other civil and political and socio-economic rights the arrangements in question are problematic. States, both lenders and borrowers, are under an obligation to conduct their international affairs by direct reference to their human rights obligations. |16| States have the obligation to give precedence to the respect of Human rights over other contractual obligations such as the debt payment. The primacy of human rights has been clearly enshrined in Article 103 of the UN Charter. |17|
What is Venezuela to do?
A situation such as the one that Venezuela finds itself today show the urgent need to pass laws against vulture funds and develop an international mechanism to protect countries struggling under the weight of their sovereign debt from these funds. Furthermore, awareness by the Venezuelan government of the complex situation helps to explain why it has refrained from exploring alternatives an instead has been willing to continue servicing its debts. As such, the government has been left gambling for resurrection. On the one hand, it has approached PDVSA bondholders in order to exchange their bonds to be redeemed later this year and in 2017 for a new 2020 series of bonds. The initial proposal made by Venezuela was rejected which forced the country to offer additional incentives to investors. As a result, the payout of the bonds increased, thus deteriorating the debt profile of the country. In other words, the short term financial pressure on the country was relieved, in exchange of creating additional burdens down the road. On the other, for a variety of reasons, it is unlikely that the rebound in oil prices that the Venezuelan government will materialize. As such, public finances of the country remain vulnerable.
Regarding the economic and social problems today and the refusal of creditors to negotiate a debt restructuration, Venezuela should consider political unilateral decisions based on international law such as the debt moratorium to force the creditors to at least negotiate a debt reduction in order to start an economic recovery. In an article published recently, Eduardo Levy Yeyati and Ugo Panizza, set out the findings of their thorough enquiry into defaulting in some forty countries. |18| One of their main conclusions is that ‘Default episodes mark the beginning of the economic recovery.
To suspend the debt payment, Venezuela can use the argument of state necessity to suspend the debt payment. In the Socobel case, it is clearly stated that “No State is required to execute, or to execute in full, its pecuniary obligation if this jeopardizes the functioning of its public services and has the effect of disorganizing the administration of the country. In the case in which payment of its debt endangers economic life or jeopardizes the administration, the Government is, in the opinion of authors, authorized to suspend or even to reduce the service of debt”. |19| Even ICSID
The International Centre for the Settlement of Investment Disputes (ICSID) is a World Bank arbitration mechanism for resolving disputes that may arise between States and foreign investors. It was established in 1965 when the Washington Convention of that year entered into force.
Contrary to some opinions defending the fact that ICSID mechanism has been widely accepted in the American hemisphere, many States in the region continue to keep their distance: Canada, Cuba, Mexico and Dominican Republic are not party to the Convention. In the case of Mexico, this attitude is rated by specialists as “wise and rebellious”. We must also recall that the following Caribbean States remain outside the ICSID jurisdiction: Antigua and Barbuda, Belize, Dominica (Commonwealth of) and Suriname. In South America, Brazil has not ratified (or even signed) the ICSID convention and the 6th most powerful world economy seems to show no special interest in doing so.
In the case of Costa Rica, access to ICSID system is extremely interesting: Costa Rica signed the ICSID Convention in September, 1981 but didn’t ratify it until 12 years later, in 1993. We read in a memorandum of GCAB (Global Committee of Argentina Bondholders) that Costa Rica`s decision resulted from direct United States pressure due to the Santa Elena expropriation case, which was decided in 2000 :
"In the 1990s, following the expropriation of property owned allegedly by an American investor, Costa Rica refused to submit the dispute to ICSID arbitration. The American investor invoked the Helms Amendment and delayed a $ 175 million loan from the Inter-American Development Bank to Costa Rica. Costa Rica consented to the ICSID proceedings, and the American investor ultimately recovered U.S. $ 16 million”.
https://icsid.worldbank.org/apps/ICSIDWEB/Pages/default.aspx , the pro-creditors tribunal, in the LG&E case about Argentina pointed out several socio-economic indicators which allowed Argentina to lawfully invoke a state of necessity. |20|
Of course, a debt moratorium and a debt reduction won’t be enough. Given the pervasive mismanagement problems that afflict the Venezuelan economy, the economic relief provided by a default and subsequent restructuring would not be enough to put back the country on a solid footing (even in an scenario were there were no legal costs associated to default). Without significant changes in the organization of the economy which should start with a transparent management of public resources is unlikely that the country will be able to break the downward spiral in which it finds itself today. A first step in this direction should be the organization of a debt audit committee. The committee should be charged with investigating the origins and evolutions of Venezuela´s foreign debt emphasizing those cases were debt arose from corruption and mismanagement. Furthermore, the committee would be a first step towards achieving an efficient and transparent management of public resources with direct citizen participation like Ecuador did in 2007-2008. |21| On the basis of the results of the audit, Venezuela is founded to repudiate the illicit, illegitimate and odious debts. At the moment, Venezuela´s debt challenges might seem insurmountable difficult but the country still has time to correct its course.
|2| Debt repayments include principal and interest for both the government and PDVSA (the state owned national oil company). Source: JP Morgan. (2015). Venezuela and PDVSA Debt: A Guide. Retrieved from http://www.innovaven.org/quepasa/ec...
|3| This figure refers to the current account balance of the country as projected by the IMF in its latest WEO. Source: IMF. (2016). World Economic Outlook Database April 2016. Retrieved from http://www.imf.org/external/pubs/ft...
|5| Its important to highlight as well the statistical treatment of the debt with China. Even though Venezuela doesnt register this debt as part of the public debt, international organizations such as ECLAC and IMF do include it as part of the public debt as it has been contracted on bilateral basis.
|14| At least not in the traditional sense. They do include a clause where 51% of the bondholders can change the terms of repayment.
|15| Voted by a very large majority (136 votes for, 6 against and 41 abstentions) by the General Assembly of the UN
|17| According to Article 103 of the UN Charter: ’In the event of a conflict between the obligations of the Members of the United Nations under the present Charter and their obligations under any other international agreement, their obligations under the present Charter shall prevail. These obligations include the promotion of universal respect for, and observance of, human rights for all‘.
|18| Journal of Development Economics 94 (2011), 95-105.
|19| Cited by R Ago, Addendum to 8th Report on State Responsibility, UN Doc A/CN.4/318/ADD.5-7.
|20| G&E Energy Corp and Others v Argentina, ICSID Award (25 July 2007), para 234.
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is a 30-year-old post-Keynesian economist from Bogotá, Colombia. MPAff. LBJ School of Public Affairs at the University of Texas at Austin. From March to July 2015 he worked as a close aide to former Greek finance minister Yanis Varoufakis, advising him on issues of fiscal policy and debt sustainability. He was previously fiscal advisor to the Ministry of Finance of Colombia and special advisor on Foreign Direct Investment for the Ministry of Foreign Affairs of Ecuador. He is considered to be one of the foremost figures in the study of Latin American public debt. He is member of CADTM AYNA.
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