Ecuador Default: Sell Into Simon Bolivar's South America

Includes: GML, ILF
by: Rakesh Saxena

The sovereign debt market is still unable to appreciate the fact that President Rafael Correa's decision to formally default on its foreign obligations on Monday is rooted in ideology, not in any shortage of funds. The ideological premise, that Ecuador's borrowings from international lenders are tainted by corruption and are thus "immoral", is certain to gather momentum in 2009. Financial institutions, pension funds and hedge funds (and, for that matter, others invested in South America) should be selling bonds and shares wherever life-sized pictures of Simon Bolivar adorn billboards and podium backgrounds.

Of immediate interest for all types of international investors are countries like Ecuador, Bolivia, Nicaragua and Venezuela. But, since the global credit crunch will create more political unrest across the continent, exit-now and short-today calls even on Brazil, Argentina, Peru, Guatemala and even Mexico have considerable underlying merit.

To compound matters, Ecuador has just received a $40 million credit line from, yes, Iran. And Russian president Dmitry Medvedev lately visited "Bolivarian" capitals promising military and industrial assistance. Those diminishing the impact of Ecuador's default (on $3.9 billion of global bonds) may be failing to grasp the fact that both, a significant component of the sovereign debt matrix and South American equities, are now subject to political risks which are extremely difficult to quantify.

Hundreds of cities in South America have a main square called Plaza Bolivar and most Latin Americans equate Simon Bolivar's early-nineteenth-century exploits with the spirit of anti-colonialism and with rather vague notions of social justice. Today, though people like Hugo Chavez (Venezuela) and Evo Morales (Bolivia) claim to be implementing Bolivarian revolutions in their respective countries, one cannot underestimate the influence of Fidel Castro's Cuba on the regional social and political milieu; it is common for politicians to blame the high-levels of ongoing domestic poverty on foreign loans, foreign capital, IMF-dictated reforms and commodity speculation.

It is the reasons for the debt default provided by Ecuador which form the basis of this sell-into-Bolivar call (GML, ILF, LTAM-LSE), not the size of the default itself. Because in the same reasons rest the prospects for unprecedented changes in legislation relating to the nationalization of mines and energy resources, in agricultural subsidy rates and in exchange rates and interest rates. No doubt South American equities and bonds have already taken a thorough beating this year. But what investors are facing today is the gradual sidelining of the fundamental principles governing private capital in the interests of populist agendas, be they Bolivarian or socialist in flavour.

More specifically, the issue is not one of an adjustment in asset valuations and of picking market bottoms; rather, widely-held, traditional perceptions of asset pricing are now at stake. For example, certain recent nationalizations of mines in Ecuador and Venezuela simply turned the value of private equity to zero, almost overnight.

As far as Ecuador's loan default is concerned, the underlying bonds were trading at 30 cents on the dollar prior to President Correa's weekend announcement—the sovereign bond markets were expecting the default since mid-September. After the announcement, the bonds have sunk to 22 cents. Obviously, credit default swaps on Ecuador are not on offer. But 5-year CDS spreads for Argentina (last at 4110 basis points), Venezuela (last at 2200 bps), Colombia (last at 380 bps), Brazil (last at 395 bps), Mexico (last at 355 bps), Chile (last at 230 bps) and Peru (last 375 bps) will certainly widen as Asia and Europe open Monday.

Disclosure: no positions