100% Yields on Ecuador Bonds: A Sign of the Times

by: Rakesh Saxena

Nobody should be surprised that rating agencies are again trying to close the barn doors after the horses have fled. But as yields on Ecuador sovereigns reached 100% on Friday, even credit default swap traders and political risk insurance principals were left wondering whether they should simply be deleting probability-driven emerging market risk pricing models from their computers.

Emerging market mutual funds manager have been deeming this year’s collapse in junior equity exchanges as an undervalued opportunity. But, after the exceptionally dramatic degradation in bond default risk spreads on Ukraine, Hungary, Russia, Argentina and Ecuador in recent weeks, the question investors must ask is this: Do their asset managers really understand what formative impact the global recession will have on highly-favoured countries like China, India, Turkey, Brazil, Russia and South Africa?

On Friday, Ecuador’s credit rating was cut from “B-” to “CCC-” by S&P, and from “B3” to “Caa1” by Moody’s. Both rating agencies now place the recovery potential for Ecuador sovereigns due in 2012 and 2013 at zero, implying that bondholders can expect no more than 10 cents on the dollar. Both rating agencies acknowledge that Ecuador’s decision to skip the coupon payment (on the 2012 bonds) due next week is more a consequence of “unwillingness” than inability to service debt; oil-exporting Ecuador has about US$2 billion cash on hand today.

What the rating agencies are belatedly recognizing is that well-argued, if not acceptable, political considerations are supporting Ecuador’s default decision. On the one hand, President Rafael Correa has been stating publicly for months that he considers foreign loans secured by military dictatorships and corrupt politicians as “illegitimate” and that Ecuador has no moral or contractual obligations to comply with loan terms. On the other hand, President Correa’s cabinet colleagues reiterate, almost daily, that any international commitment, made by previous administrations, which conflicts with the anti-poverty (Bolivarian) social agenda will be not be met.

Shades of Fidel Castro and Hugo Chavez? Quite clearly, yes. However, emerging market investors still need to address two questions before they heed Wall Street analysts who are continuing to issue “buy” signals. Firstly, as far as Latin America is concerned, will Nicaragua, Bolivia, Guatemala and Peru follow Ecuador’s lead and encourage revisions to their sovereign bond obligations? Argentina already has its own default-to-restructure history. Secondly, will deteriorating economic and consumer conditions force non-Latin American political leaders to enact legislative changes (e.g. currency controls, food subsidies, taxation, leverage caps and protectionist measures) which will lay the foundations for a comprehensive revaluation (down) of emerging market assets?

While it is indeed critical that investors not embroil themselves in any type of ideological debate, one cannot ignore the populist nature of the thesis that the failure to diminish or eradicate poverty amongst huge proportions of third-world populations, despite IMF and World Bank interventions, is now threatening to bring real growth (not GDP numbers) in dozens of emerging economies to a grinding halt in the first half of 2009.

For that matter, why are these developing country governments being asked to implement stimulus packages if their growth rates are between 5 and 10 percent? Or, are these growth rates bogus? Remember, if a truckload of toxic chemicals spills somewhere, the money spent cleaning it up counts towards GDP. When near-famine conditions exhaust all natural sources of water, the money spent on bottled water is added to GDP. When the lack of basic preventive health care leads to serious illnesses, medical costs also contribute to GDP.

In brief, GDP, by its very nature, has the ability to convert harm and waste into positive gains, and independent, verifiable data (not government-generated statistics) shows just that; this conversion process has been rampant right across the emerging market spectrum for the better part of two decades.

Recommendation: Stay out of emerging market ETFs, or sell on rallies for healthy profits as deleveraging gathers momentum.

Disclosure: none

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