Emerging-market debt after Ecuador

By Felix Salmon
June 8, 2009

EMTA, the erstwhile Emerging Market Traders Association, hosted an in-depth session today on the debt markets in developing countries, both sovereign and corporate. And it’s the corporate bonds which are by far the biggest worry: emerging-market corporate loans are now five times the size of the corporate bond market. And JP Morgan’s Joyce Chang came out with one of the scariest sets of datapoints I’ve come across in a while. Get this:

  1. Total lending to emerging markets is now some $4.7 trillion.
  2. 74% of that was lent by European banks.
  3. Both Austria and Netherlands have lent more than 50% of their GDP to foreign developing nations.

It’s not just Latvia that’s in serious trouble: as Joyce said, a devaluation in Latvia could easily spill over to Bulgaria. At that point there are risks of 1997-8 all over again, only this time starting in Europe rather than Asia.

There was quite a lot of talk of how come the IMF and other multilateral institutions aren’t encouraging emerging-market countries in fiscal distress to reduce or attenuate their liabilities — there’s your answer right there. If emerging Europe started restructuring its debts, the pain in the EU would be enormous — and of course the G8 essentially controls the IMF and the multilaterals.

If the official sector is becoming friendlier to private-sector creditors, however, the big news today was the degree to which Lee Buchheit, the godfather of sovereign debt, has followed suit. Buchheit is an institution, both within Cleary Gottlieb, his law firm, and the sovereign-debt community more generally. He has represented dozens of sovereign debtors, and is known as the inventor of the exit consent — a tool by which countries can eviscerate the legal rights of minority bondholders. Up until very recently, he was considered by most private-sector bondholders to be the enemy; one of them described him to me once as an “evil genius”.

But Lee was singing a very different tune today, and unloaded with both barrels on his former client, Ecuador, and its president, Rafael Correa. Ecuador is a “rogue debtor”, he says, and its most recent default is pretty much the first time in 30 years that a country has defaulted without at least “a colorable claim to distress”.

Ecuador’s offer to its bondholders, said Buchheit, was “an extraordinary document unlike anything I’ve ever seen in this business”. Where most countries in distress at least pay lip service to the idea of wanting (just being unable) to pay, Ecuador repudiated its bonds outright, and said that it considered itself to have no legal or moral obligation to pay so much as a penny for them. That strategy was, no doubt, highly effective. But a large part of its success was due, said Buchheit, to the fact that the bondholders’ trustee — US Bancorp — “was bovinely passive” in the face of extraordinary provocation.

Buchheit did suggest that future sovereign bond issues will likely include clauses barring countries from defaulting and then buying back their distressed debt — not that such a clause would be remotely sufficient to stop a country like Ecuador which has little if any respect for international law. The bigger issue, said Buchheit, was those trustees. “What do you do to motivate the trustees to behave in an appropriate manner?” he asked, adding for good measure that “trustees are a species under the broader genus of invertebrates”.

One of the problems is that when trustees are chosen, they’re generally picked not on the basis of how hard they’re likely to fight for bondholders when push comes to shove, but rather on the basis of how cheap they are. But in general trustees are nearly always legally protected from bondholders, which means that if they take the easy and lazy way out and never kick up a fuss, they’re not going to be held liable for doing so. At the same time, of course, kicking up a fuss is an expensive and time-consuming thing to do. So there’s a lot of incentive to do nothing.

Buchheit was very worried about the consequences of Ecuador’s default. “Outliers tend to be infectious,” he said. “And once you establish a precedent, other countries and finance ministers will wonder why they should go through the tiresome business of negotiating with bondholders,” rather than just defaulting and buying back at pennies on the dollar.

Rafael Correa is no idiot. He has observed, said Buchheit, the tendency of the bond markets to forgive and forget much more quickly than bank lenders: “Financial markets today tend not to hold grudges the way that predecessor financial markets used to. So the traditional cost of a brutal restructuring is not one that they have to pay any more.”

And so, in the face of Correa’s provocation, Buchheit is speaking out. Most of his sovereign clients are keen to retain their access to the international capital markets; many of them are net creditors. So they no longer want their lawyer to stand up for sovereigns’ rights, so much as to repudiate actions by Ecuador which might well imperil their own ability to borrow money in future.

It’s truly a strange world, where distressed-debt investors like Hans Humes make nice noises about the IIF and formal restructuring mechanisms, while Lee Buchheit speaks out against “rogue debtors”. Might it be that out of this crisis is being forged a new consensus? I’m not holding my breath; these people almost never agree for long. But so many unthinkable things have happened already that nothing would shock me any more.

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