Vultures attack Peru!

 In 1968, a left-wing military government ascended to power in Peru. It expropriated a lot of things, not least a bunch of American investments. The Americans had the power of the United States behind them: as I explain here, they were more than fairly compensated. Domestic Peruvian landowners, however, were of no interest to Richard Nixon. They were forced to accept Agrarian Reform Bonds denominated in the local currency and paying between 4% and 6%  interest over 20-30 years. (See page 5.) 

Unfortunately for everyone involved, the Peruvian government stopped paying interest on the bonds around 1982. (See page 4.) Why they defaulted, I could not tell you: the country was entering a period of hyperinflation that reduced the effective value of those bonds to zero. If the Belaúnde and García administrations had just kept on paying, the debt would have been inflated to nothing and the current government would have been spared a major headache. 

But default they did, and thus the current problem. In 2001, the Constitutional Tribunal declared that the government had to repay the bonds with some adjustment for inflation. To do otherwise violated Article 70 of the Peruvian constitution: “No one shall be deprived of his property, except, exclusively, on grounds of national security or public need determined by law, and upon cash payment of the appraised value, which must include compensation for potential damages.”

The decision was not a surprise to the Peruvian government. In 2000 the Fujimori administration (then on its last legs) issued a decree which said that the government would honor the unpaid debt by converting it into U.S. dollars at the exchange rate prevailing at the date of issue and then applying a 7.5% interest rate, compounded annually. So far so good ... except the government did not move to pay cash. Rather, it moved to issue interest free debt for the face-value of the bonds due in 2030. In other words, the compensation offered was fair, but wouldn’t be paid for three decades. (Page 16.)

The creditors were not satisfied. When the new Toledo administration proved unwilling to alter the terms of the Fujimori offer they went back to court. In 2004 the Tribunal declared that bondholders could accept the government’s terms, but only if they wanted to. So it went back into the government’s lap.

The Toledo administration ran out the clock and handed things over to incoming President Alan García in 2006. (Yes, that would be the same García who helped create the problem when he was president in 1985-90.) President García did nothing, handing off the problem to the newly-elected Humala administration in 2011.

Three months after President Humala’s inauguration, the bondholders sued again. In 2013, they got a decision. The Tribunal once again ruled that the government had to pay. But the Tribunal also said that the government didn’t have to simply run the value of the debt through the Peruvian CPI, because that would lead to number so high that it would break the Peruvian fisc. (Page 18.) It suggested rather that the value of the bonds be converted into U.S. dollars, which would then be compounded at the contemporary rate on one-year U.S. Treasury obligations.  

Basically, the method gives the bondholders what they would have earned had they plonked their money into one-year T-bills back in 1969 and kept renewing them. Maybe not fair, but not patently unfair either: the rates on T-bills were higher than the 4%-6% coupons on the original Peruvian bonds until around 2001. (See below.)

How much money are we talking about? In 2006, the total unpaid principal came to about 2.5 billion old soles. (They were actually called “gold soles,” but old soles is more straightforward.) Adjusting for inflation the simple way (which, remember, the Tribunal said not to do) would bump that up to 10.0 billion new soles, or US$3.5 billion, plus unpaid interest. The investors claim that they are owed $5.1 billion with interest using this method. (Page 7.) 

Using the suggested Peruvian method (compounding at contemporary T-bill rates, see page 2), the 2006 value of the debt would be around 1.9 billion new soles, or US$568 million, assuming that it all dates back to 1969. (I have interpolated for the missing years. Data from the Fed here.) Unpaid interest included. 

Alternatively, the government could just convert the debt to dollars at the exchange rate at the date of issue and compensate investors at the interest rate they were promised. At 6%, that would come to 1.7 billion new soles, or $531 million. (The actual amount would be lower, since the actual coupons varied between 4 and 6 percent.) The result would also be similar to assuming that the investors would have plonked their money into long-term T-bills: the 20-year Treasury bond yielded 6.32% in 1969. At that interest rate you get a 2006 value around $595 million. 

So far, so good; it may not be what the bondholders want, but the proposed method seems to give fair and reasonable values. So why are vulture funds involved? What is all the yelling about?

Well, the government proposed that the value of the bonds be converted to U.S. dollars not at the 1969 official exchange rate of 38.7 per dollar, or the open market rate of 43.5 (which the above calculations use) but the somewhat absurd rate of 1,029 per dollar. (Page 8.) 

Under that calculation the debt would have been worth in 2006 (for comparability) 78 million new soles ... or only $24 million. 

My. That is some difference! Add to that insult the injury that the government intends to compensate different bondholders in different ways and still has not made it clear whether they will be paid in cash, bonds with a market value around the equivalent amount in cash, or some other method. Plus other stuff. But that exchange rate calculation is where the Peruvians are giving the bondholders a giant middle finger and the real source of the trouble. 

So now the vulture funds intend to attack Peru, first in Peruvian courts, then using the stipulations in its Free Trade Agreement with the United States. If that fails, they will presumably do the full Argentina. I cannot say if they will be successful, but Peru (unlike Argentina) needs outside funding. 

I understand why Peru is wary. The national debt is a little under $38 billion, with about $18 billion of that owed to foreigners. Interest on the foreign debt amounts to about $1 billion per year. Why add to that? 

But still. There is something a little gratuitous about this, even for me. The $5 billion that the bondholders want is too much, but something on the order of $500-$600 million is entirely reasonable and entirely affordable. Lima should pay.

Comments

[Federico]

Hi Noel. I was really excited to read about Gramercy moving forward on this, if only to see how it plays out (plus another Argentine type soap opera would be very enjoyable). Do you know how the plaintiffs plan on using the FTA though? I haven't seen any explanation of this. Thanks!

[Noel Maurer]

Well, the plaintiffs probably don't have a legal strategy yet, but they're going to claim expropriation under Chapter 10 of the agreement and submit a claim to ICSID. The details are in Chapter 10.16, here:

https://ustr.gov/sites/default/files/uploads/agreements/fta/peru/asset_upload_file78_9547.pdf

ICSID is the likely venue, although others are possible.

Will it work? I doubt it, but who knows? Arbitral tribunals are not bound by precedent. This April, and ICSID panel refused to hear a case about Greek bonds. On the other hand, an Argentine case is going to a panel. I can see grounds for dismissal (see Article 10.13 in particular) but again, who knows?

The main thing to note is that arbitration is slow. Even if Peru loses, nobody will see any money until 2020 at the earliest; more likely 2022-24.

[Alex]

Question: I can see an argument that Lima should pay up something and make nice, but doesn't the existence of the vulture fund business model kind of ruin the very idea of settling with your creditors?

After all, whatever they offer, if it isn't full payment of the highest colourable valuation of the claim (and we're talking a over/under of $500m to $6bn here - there is a lot of scope to pad it), it's always open to the vultures to reopen the issue and come back looking for more.

If Peru could expect that the $500m would close the book on the whole business, that would make a lot of sense, but if it's just $500m of danegeld and the buggers will be back in a year's time, well, telling them to whistle is more attractive by about $500m.