Political Risk Prices Indicating Sharp Fall in Emerging Markets

The direction of credit default swap spreads is certainly pointing towards further potential downside in emerging market equities. But, more importantly, it is the state of the political risk and trade paper insurance marketplace which is now making a compelling case for another 25%-plus decline in junior stock indices during the course of 2009.

Swiss Re [RUKN.VK], the world’s second largest reinsurer, claims that the recent pickup in risk insurance premium rates is good for business. Unfortunately, premium rates in key sectors have risen to levels which ensure that there may no business to write at all.

While, in addition to Swiss Re, major reinsurers like Munich Re [MUV2.GY] and Hannover Re [HNRI.GY] have identified both mark-to-market losses on credit default swaps and impairments in investment portfolios in recently issued financial statements, there has been no clarity on capital adequacy requirements governing political risk insurance contracts. Hundreds, if not thousands, of political risk buyers will be calling for compensation during the course of 2009. Just over the weekend, for example, while rising tensions between India and Pakistan have been sending shivers through the Lloyds-affiliated political risk, shipping and trade insurance underwriting pools, the prospects for extended civil strife in Thailand are forcing rice exporters to seek risk coverage which is either too expensive or simply unavailable.

Due essentially to the irrelevance of Bolivia, Nicaragua, Venezuela and Ecuador in emerging market indexes, exchange-traded funds (e.g. EEM and VWO) were largely unaffected by the nationalization of mining and energy assets. But the counterparty-risk contagion has infiltrated right across the business fabric of the emerging markets, and it is only a matter of time before massive defaults in trade credits enter the public domain. Such defaults will inevitably gather momentum once the reality of the new political risk umbrella dawns on third-world corporate entities.

Late Friday, despite the widening of 5-year CDS spreads for India (425 basis points) and Thailand (330 basis points), the bid side was extremely thin. But of greater concern must be the 100%-plus hike in indicative annual political risk premium rates, from 2.5% to 5.25% for India and from 1.5% to 4% for Thailand; nobody expects any respite in premium rates when the London reinsurance market opens on Monday.

Of more immediate relevance is the influence political events have started to exert on the price of insurance and trade guarantees. While a nuclear war between India and Pakistan may appear to many a remote possibility, political risk-offset providers need to price that possibility when quoting risk. In that respect, political risk insurance and trade forfaiting (i.e. purchase of export receivables) rates are a more accurate reflection of where the emerging market economies are headed, since they directly or indirectly incorporate adverse legislative changes, currency exposures, exporter margins, counterparty credibility, political turmoil and timeline risks.

So, regardless of the optimism of Swiss Re, it is difficult to see emerging market businesses affording the revised premium rates. And it is even more difficult to draw reasonable risk-reward profiles which will justify multinational investments (in the emerging markets) at such rates.

The month of December should provide ample opportunities (i.e. rallies) to short emerging market ETFs, opportunities which now qualify as portfolio imperatives for investors preparing to face the steady stream of recession-related data in forthcoming weeks and months.

Disclosure: Author holds short positions in EEM and VWO

Comments

[notsosmart:]

if your investing best to invest with the local scoundrels instead of off shore.

2008 Nov 30 12:44 PM