Felix Salmon

Thanks to Mohamed El-Erian for pointing this out in his latest Secular Outlook: the market risk spread on advanced economies now exceeds that on emerging economies.

Here’s Pimco’s explanation for what we’re seeing in this chart:

The difference in spreads shows the 5 year Markit CDX.EM.15 index minus the 5 year Markit iTraxx SovX G7 Index Spread. A positive number implies that Emerging Markets sovereign spreads are greater than Advanced Economy sovereign spreads. A negative number implies that Emerging Markets sovereign spreads are less than Advanced Economy sovereign spreads and therefore, the market implied credit risk for EM is lower when the spread is negative.

This is a very big deal, because the names in the EM.15 index are not exactly paragons of creditworthiness. Here’s the list: it starts with Argentina and Venezuela, and goes on from there, including countries like Panama, Russia, and Ukraine.

Meanwhile, the SovX G7 list is short and powerful: Germany, France, Japan, Italy, UK, and USA.

There are probably technical reasons why a group of AAA-rated sovereigns is trading wide of a group of much less creditworthy emerging markets in the CDS market. But the big message here is clear: the world is being turned upside-down. And most investors have yet to even start adjusting to these new realities.

Update: Turns out that the chart wasn’t measuring the G7 spread after all, but rather the Western Europe spread, which includes all the PIIGS.

Landon Thomas’s report from Montenegro is full of fun datapoints, including the fact that the prime minister, Milo Djukanovic, officially gets paid only 1,256 euros per month. There’s also a delicious irony in the fact that he avoided prosecution by Italian authorities by declaring diplomatic immunity. And then there’s this:

As part of the plan to lure investors from around the globe, Mr. Djukanovic, who is also chairman of Montenegro’s investment promotion agency, said last week that any person willing to invest 500,000 euros or more could become a citizen of Montenegro…

Government officials say that the new applicants under the citizenship program will be thoroughly vetted by outsiders like Kroll, the risk consulting company.

Kroll, of course, is the company which was instrumental in allowing Allen Stanford’s $8 billion Ponzi scheme to go on for as long as it did. It’s also the kind of company which tries to hire freelance journalists to be its spies, because they are seen to be independent and above suspicion:

With one Google search, anyone could see that I was, in fact, a journalist. If I went to Lago Agrio as myself and pretended to write a story, no one would suspect that the starry-eyed young American poking around was actually shilling for Chevron.

I’m not entirely impartial here. Back when I was a freelance journalist, one editor would do things like ask me to write a story for his magazine, and then, after I filed it, tell me that I was an idiot to write it without a signed commission letter and that he wouldn’t run it or pay me. He went on to become a top Kroll executive in Brazil.

But putting all that to one side, I’m a bit confused about what exactly Montenegro is trying to achieve by making a big show of hiring Kroll to vet potential citizens. It’s not going to convince anybody that Montenegro isn’t plagued with corruption — quite the opposite. And Kroll doesn’t come cheap, even if you’re a country of only 670,000 people — so the country has to be getting some benefit from this contract. I wonder what it might be.

Yesterday was the EMTA annual meeting, complete with its venerable and always interesting panel of buy-siders. My favorite is always Hari Hariharan of NWI managment: when asked what his favorite trade is, he never says something simple like “long Brazil”. Instead, it’s invariably a complex relative-value trade: this year he said that “a one year forward 2s-5s steepener in Korea could be an offsetting trade to receiving front-end Mexico”. You’re welcome.

Hari’s a smart and insightful guy, though, he’s not (just) a nerdy quant. When asked whether we were in an emerging-markets bubble, he pointed out that although property prices in Hong Kong are hitting insane levels in the region of $9,000 a square foot, those prices are being paid in cash, and banks aren’t lending against those values. And without leverage, of course, there’s a limit to how much harm a bubble can cause.

Similarly, I get the feeling that for all that Brazilian equities have been skyrocketing in dollar terms of late, that doesn’t mean that Brazilian companies have anything like the same access to the equity capital markets that they did before the crash: the primary markets haven’t recovered as well as the secondary markets, and people spending new money are still displaying signs of caution.

What’s more, in spread terms, emerging markets aren’t looking particularly bubbly, at least by 2007 standards when the EMBI+ index got as tight as 153bp over Treasuries. Right now, it’s 317bp over. In yield terms, however, things are much closer: 6.51% now (or yesterday, anyway, when the panel was going on and before the jobs report came out) compared to 6.37% at the low in in June 2007.

Mark Dow, of Pharo management, added that right now it’s easy to see bubbles everywhere, since we’re still so burned from the bursting of the last one. It’s a good point: while emerging-market assets may or may not be overpriced right now, it’s probably not particularly helpful to worry about bubbles. That said, everybody was a bit worried about the tens of billions of dollars flowing into Brazil from Japanese toushin funds: they’re not good for Brazil, and they’re unlikely to work out very well for Mrs Watanabe, either.

So although there’s bound to be some sort of correction in Brazil and other emerging markets sooner or later, that doesn’t mean they’re currently in a bubble. It just means that traders are making lots of money on the momentum trade right now, which isn’t the same thing at all.

The Economist has a good short overview of the situation in Dubai, which includes this interesting take:

Investors had half-expected Dubai World to seek forbearance from its bankers, asking them to extend their loans. But they felt sure the emirate would make good on publicly traded instruments, and in particular Nakheel’s sukuk, rather than suffer further damage to its financial reputation.

I remember the days when investors felt that in the world of emerging markets, publicly-traded bonds were implicitly senior to bank loans. But those days came to an end in the late 1990s with bond defaults in Pakistan, Ukraine, and Ecuador — and they’ve never returned. And it’s not even obvious at this point that restructuring loans is easier than restructuring bonds.

Certainly any entity like Dubai World carrying a large amount of bank debt would be very wary about needlessly infuriating its bankers by defaulting to them while remaining current on its payments to bondholders. If Dubai World’s bondholders really took solace in the fact that they held bonds rather than loans, they thoroughly deserve a large hit in the wallet. And as Willem Buiter says, it’s a good thing too:

Property developers tend to be highly geared and very procyclical in their revenue flows and access to the capital markets. During construction slumps they drop like flies. Because the property sector is risky (ask Donald Trump), its creditors tend to get better interest rates than the sovereign rate. Dubai is no exception to this rule. If you earn a risk premium during good times, you should not moan when the borrower defaults from time to time when the going gets tough…

Property companies don’t fall into the systemically important category. Their collapse is painful for their shareholders, creditors and, if the local labour markets are weak, their employees. They are not, however, systemically important. Their collapse will not threaten the delicate fabric of financial intermediation. They are fit to fail. Creditors beware.

This chart (via Paul) I think is too meek: of course the current emerging-markets boom is debt-financed. And boy does it look bubblicious, what with the Bovespa having doubled in the past 12 months and rapidly approaching its all-time high. I’m a believer in the long-term future of Brazil, and even count a Brazilian ETF among my few investments. But at this point any investment in emerging markets looks very much like a speculative momentum play: don’t invest anything you can’t afford to lose.

John Authers thinks that since emerging-market bourses have outperformed developed-market indices over the course of this stock-market rally, investors are betting on decoupling:

The underlying trend is clear; rightly or wrongly the market believes that China and the other emerging markets will pull the world through.

I don’t think that’s clear at all. Given the degree to which emerging-market stocks underperformed on the way down, it’s only natural for them to outperform on the way up.

Emerging-market stocks are high-beta assets, and in times of general volatility, as we’ve seen over the past couple of years, they exhibit really high volatility. You need a strong stomach to invest in them, and you’re likely to get whipsawed quite a lot. But as a result, trying to extrapolate a big-picture global macroeconomic forecast from a relatively short-term movement in emerging-market stock indices is a fool’s game. I don’t think that EM stocks have ever been good forecasters of anything; there’s certainly no reason to believe they’re demonstrating something in particular right now.

Ecuador has closed out its bond exchange offer at the higher end of expectations, paying 35 cents on the dollar to investors who hold the 2012 and 2030 global bonds. That’s higher than the bonds have traded all year, and certainly higher than they have traded since Ecuador defaulted — which means that any vulture investors who bought the bonds in default will be able to lock in a decent profit for doing essentially no work at all.

What’s more, Ecuador has announced that anybody who put in an offer higher than 35 cents will be allowed to re-tender at the 35 cent level. This makes sense from Ecuador’s point of view, and gives people who tendered high the opportunity to re-think their strategy in the light of known events. It’s pretty clear that at this level a supermajority of the total bonds outstanding will end up being owned by Ecuador — which means that Ecuador will have the ability to strip a lot of creditor protections out of the instruments.

Ecuador has suffered no negative repercussions from its actions — quite the opposite. If the country needs any money in the next few years, it’ll be able to get it, from the Andean Development Bank or the Inter-American Development Bank or the World Bank or even the International Monetary Fund. None of them seem to particularly care that Ecuador defaulted on its global bonds, and emerging-market bondholders are so weak and fragmented these days that they hold very little sway any more within international financial institutions.

Indeed, given the short memory of emerging-market bondholders, I wouldn’t be surprised to see Ecuador regain its access to the international capital markets within a few years, thanks to the way in which it has managed to substantially reduce its (already pretty low) debt-to-GDP ratio. That could well be the thinking behind the decision to remain current on the 2015 global bonds, which were issued when current president Rafael Correa was finance minister. Look, he’s saying: we pay back the money that we borrow. We just don’t pay back debt which was originally borrowed decades ago and which was restructured twice in a manner designed to be as friendly as possible to private-sector creditors.

Looking at this from a systemic perspective, it’s pretty clear that in this instance the cost of default, to Ecuador, was negative. That’s dangerous: it radically increases the probability of tactical defaults from all manner of other countries, including Argentina, Venezuela, and various African states. And once a wave of sovereign defaults starts, it’s very difficult to stop, since the cost of default drops with each new event. Right now the risk of such a wave is surely near a multi-decade high.

According to Ecuador’s finance minister — and there’s no reason not to believe her — there’s been “excellent” take-up of her offer to buy back Ecuador’s 2012 and 2030 bonds at somewhere in the neighborhood of 30 cents on the dollar. As Reuters’s Maria Eugenia Tello notes,

Most holders of defaulted debt have so far failed to create a united front against Ecuador to seek repayment via courts.

This is in contrast to what happened the last time the Ecuador defaulted, in September 1998. Back then, Ecuador made the announcement in the middle of the annual meetings of the IMF in Washington, and substantially all of Ecuador’s bondholders were in the same place at the same time. It didn’t take long for them to organize meetings and reject Ecuador’s offer to pay some bonds in full while in other cases using the bonds’ own built-in collateral to keep current.

Why do bondholders seem to have lost cohesion over the past decade? At the time, I thought that the experience of Ecuador’s 1998 default was going to be the event which catalyzed bondholders to come together as a much more unified bloc — and indeed the Emerging Market Creditors Association was formed as a direct result of the way that the Ecuador default was handled.

But EMCA fell apart, nothing really took its place, and a major global financial and economic crisis kinda took the wind out of bondholders’ sails. At this point, most of them have neither the energy nor the time horizon nor the levels of capital needed to rally and fight — Ecuador’s timing, you could say, is perfect in that regard.

What’s more, any holdout strategy is fraught with risk:

Many market watchers on Wall Street say Ecuador has a key advantage because Correa had already bought back most of the debt when the country started to threaten a default and dragged down market prices in late 2008. Ecuador has not confirmed or denied past buybacks.

The point here is that if and when Ecuador controls a supermajority of the bonds — which it certainly will by the time the exchange is over, if it doesn’t already — it can start modifying a lot of the covenants in them, making a court fight that much more difficult. Most hold-out or “vulture” creditors tend to dislike litigating bonds in any event, preferring loans instead, which tend to have stronger covenants.

So if there are any hold-outs, their best hope will be that they’re in a tiny minority, and Ecuador just does what it did last time, and pays them off in full because it’s easier and cheaper than fighting them in the courts. But the hold-outs would probably need to amount to less than 4% of the amount issued before Ecuador went down that route.

Will there be 96% takeup of this offer, including bonds Ecuador already owns? It’s possible, but I suspect that there will be enough too-high bids, in the 40-cent-and-over range, to stop that from happening. In which case Ecuador’s holdouts will find themselves in much the same position as Argentina’s. Which is to say, an unhappy position indeed.

One of the great things about working for Reuters is that if an important story appears on the wire, I can agitate to have it put online as well. So go and read this, by Alexandra Valecia and Alonso Soto: the astonishing yet seemingly all-but-missed news that Ecuador’s audacious and dangerous decision to bite its thumb at the entire international financial community has seemingly been ratified by not only its Andean neighbors, the owners of the Andean Development Corporation, but also by the international community more generally, in the shape of the Inter-American Development Bank.

The Andean Development Corporation’s representative in Quito, Luis Palau-Rivas, said the lender sees the OPEC-member nation’s defaulted debt restructuring “positively.”

“We see the process positively because it’s a voluntary process,” Palau-Rivas told reporters. “It’s helping to solve a difficult situation … and will benefit everyone.”

Palau-Rivas said the CAF was planning to disburse up to $700 million in loans to Ecuador in 2009. From those credits about $450 million will go to the public sector.

The IADB also said it was seeing progress in Ecuador’s talks with bondholders.

“The good results obtained (in the restructuring) will benefit all Ecuadoreans during difficult times,” the lender’s representative, Carlos Melo, said in a statement. “The IADB reiterates its predisposition to work alongside Ecuadoreans to promote economic development.”

This is absolutely astonishing stuff. Historically, private lenders have looked to the multilaterals having what’s known as a “lending-into-arrears” policy, whereby countries which needlessly and gratuitously default on their debts get cut off from international funding.

In this case, Ecuador had more than enough money to pay all of its debts, but defaulted for nakedly political reasons, and is now in the process of buying back its defaulted debt for little more than 30 cents on the dollar.

The idea that this is “a voluntary process”, as Palau-Rivas says, is utterly ridiculous: the bondholders have had no say whatsoever in what has happened, and their only choice is whether to accept Ecuador’s risible offer or to hold onto defaulted Ecuadorean paper indefinitely.

And it’s far from clear that even if the restructuring does generate “good results”, the consequences “will benefit all Ecuadoreans”. Indeed, it’s quite likely that the opposite will be the case — that Ecuadoreans, cut off from private-sector funding and investment, will find themselves shunned for the foreseeable future.

But never mind Ecuador — what message does this send to the rest of Latin America, not to mention Africa and the rest of the world? The multilaterals seem to be saying that they will embrace any default, no matter how egregious, and that the best strategy for any indebted nation is to simply force its lenders to write off the vast majority of their loans. This is likely to backfire massively not only on the multilaterals themselves — which of course have billions of dollars in debts outstanding to the likes of Ecuador — but also on the countries in question, most of whom who want to be taken seriously but all of whom must now be considered highly suspect credits, given the incentives being put in their way by CAF and the IDB.

I can’t imagine that these statements from CAF and the IDB were made without the foreknowledge, if not the outright approval, of the Obama administration, and that worries me a lot. Somebody should ask Lael Brainard, the nominee to be undersecretary for international affairs, what she thinks of all this. For that matter, somebody should ask Larry Summers and Tim Geithner, both of whom held that job in the past, what they think. In the midst of a major domestic financial crisis, I fear some nasty precedents are being set internationally with nobody noticing.

Here are the official details of Ecuador’s exchange offer — the one where it’s attempting to buy back its own debt at 30 cents on the dollar.

The 108-page document kicks off with a letter from the finance minister, Maria Elsa Viteri Acaiturri, where she talks about “alarming… indications of illegality and illegitimacy” in the process which led to the issuance of the 2012 and 2030 bonds which Ecuador has defaulted on. She then however continues:

The Invitation is designed to assist in allowing both the 2012 and 2030 Bondholders and the Republic to close, on an acceptable basis, a very challenging period in Ecuador’s external debt history.

We appreciate your understanding and consideration and we look forward to restoring normal relations with the national and international investor community.

I think she’s serious, and honestly believes that buy unilaterally and unnecessarily defaulting on some (but not all) of its bonds, then buying those bonds back at about 30 cents on the dollar, Ecuador might be able to achieve “normal relations with the national and international investor community”.

Viteri doesn’t make threats in her letter — those come later in the document, on page 13 of the document (page 19 of the PDF):

Bonds acquired by the Republic (or a person nominated by the Republic) pursuant to the Invitation may be held by the Republic or the nominee. If a nomination is made, it is the Republic’s intention that the nominee will acquire all rights, including, if the Republic does not control the nominee, rights in respect of voting currently exercisable by Holders or beneficial owners of the Bonds that are accepted pursuant to the Invitation. The Republic will then consider a range of amendments to the Bonds, which it will propose to Holders after the Settlement Date. Certain amendments to the Bonds may be made by the Republic and Holders of a simple majority by value of the Bonds.

In English, Ecuador is saying that after this tender offer is over, it’s going to control a majority of the bonds — and that it will happily strip away from the bonds a large swathe bondholder protections embedded in the bonds at that point in time.

I’m not sure how much of a threat this really is: Ecuador tried a very similar tactic in 2000, with its notorious “exit consents”, and when it issued the new 2012 and 2030 bonds as part of that transaction, it limited itself as to the protections which could be stripped in such a manner. But still, I’m sure that Ecuador could cause no little mischief this way — especially considering that it has almost certainly bought up a large number of the bonds already.

My favorite bit of the document comes later, however:

The Constitution defines its goals in terms of multiculturalism, pacifism and relations with our neighbours, including… achieving Sumak Kawsay, a life in harmony with nature.

Is this the first time that principles of harmony with nature have been literally embedded in a sovereign debt exchange offer? And what do such principles mean for bond valuations? Perhaps we’re about to find out.

Eventually, the document gets around to explaining why Ecuador’s debt load is so burdensome that it’s being forced into this offer:

The Republic’s economy is estimated to have grown at a rate of 5.3%, in real terms, in 2008. The balance of the foreign debt was U.S.$10.0 billion, which was approximately 19.2% of GDP. As of December 31, 2008, the freely disposable reserves amounted to U.S.$4.4 billion.

Remember here that the total amount of the bonds in question is no more than $4 billion; Ecuador is current on all of the rest of its debt, and claims to have no intention of restructuring any of it. Meanwhile, Ecuador grew by 5.3% last year — one of the best economic performances in the world; its total debt load has actually been shrinking of late; and its debt-to-GDP ratio is so low that it could easily be mistaken for a budget deficit in more profligate countries.

In other words, Ecuador has no economic rationale whatsoever for defaulting on this debt: it’s doing so because it can, basically. I suspect that bondholders will prove unimpressed, and will tender very few bonds into this exchange. If you’re still holding Ecuador bonds right now, you’re doing so because you don’t need the coupon income. Eventually (although not in this election) the current administration will be replaced with one which is friendlier to the market. Most of Ecuador’s bondholders can wait until then, or else try their luck in the Southern District of New York in the meantime.

Liberia, with the aid of the World Bank, has been negotiating with vulture funds holding $1.2 billion of its debt. You know what vulture funds are, right? They’re evil hedge-fund types who buy up debt at pennies on the dollar, and then sue for repayment in full, with interest and penalties and everything.

Just look at the deal they drove in this case! Liberia, one of the poorest countries in the world, is going to have to pay them, er, nothing at all. The World Bank is kicking in $19 million, a few rich countries are matching that sum, and the vultures are walking away with a not-very-princely-at-all $38 million, or just 3 cents on the dollar. Which probably barely covers their legal fees, let alone the amount they paid for the debt in the first place.

Meanwhile, Ecuador has come out with its own offer to bondholders: 30 cents on the dollar, which is either a “minimum price” (Bloomberg) or else just a starting price which the finance minister expects to fall in a “modified Dutch auction” (Reuters). Dow Jones says it’s a modified Dutch auction with a minimum price of 30 cents on the dollar; in any case, what’s clear is that no one is going to pay much attention to the technicalities until the current government is re-elected next week and all the electoral noise is in the past.

There are many more questions than answers right now on the Ecuador front. For instance, if the bondholders do accept the offer, where will the money come from? How will the auction work? What’s the minimum number of bondholder acceptances needed for the offer to go ahead? If the offer fails, will the Ecuadoreans continue making the coupon payments on their 2015 bonds in full? And since the secondary-market price of the defaulted bonds seems to refuse to fall below the 30-cent level, why would anybody take the government’s offer rather than just sell in the secondary market?

But still, the Liberian precedent will be sobering for anybody thinking about a vulture-like holdout strategy. Sometimes, holding out can pay handsomely: after the last distressed Ecuadorean bond exchange, the small number of holdouts was paid off in full. But as the Liberian example shows, it’s a very high-risk gamble, and it can end up in utter failure.

OneEyedMan, in the comments, makes a good point about the cost of default:

If you have less outstanding debt, even after a bankruptcy discharges it, then you are immediately less likely to default. However, in comparison with another firm that doesn’t default, if at some future date you have the same financials, expect the debt markets to charge you more to borrow money. That’s how the UK was able to beat up France time and again. By not defaulting on their debt they had lower borrow costs so they borrowed more. Borrowing more funded bigger wars.

This is a very good encapsulation of one of the big theses of James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy. And it has an interesting implication about the cost of default: it’s much higher for entities which have never defaulted before than it is for those who have defaulted in the past. Or, to put it another way, the cost of a second default is a lot lower than the cost of a first default, and the cost of a third default is lower still.

Maybe this means that in times of global upheaval, like today, it makes sense to look to countries like Colombia if you want to minimize credit risk. And indeed, Colombia is trading at a spread of 445bp over Treasuries, which is pretty good, these days: Hungary is at 567bp over, for instance, despite being a member of the EU.

On the other hand, Peru has not only defaulted in the relatively recent past, but even did so under its current president, Alan Garcia. And it’s trading at an enviable 393bp over. So clearly the stigma of having defaulted can be overcome.

Matthew Turner points me to this rather interesting datapoint from the IMF’s International Financial Statistics for Ecuador. The country’s has had 845,000 ounces of gold for as far back as the statistics go — until January 2009, when they jumped to 1.76 million ounces, and then February 2009, when they rose further to 1.93 million ounces. That’s an increase of 1.085 million ounces (or about 37 tons of gold) in the space of two months — which at present prices is worth almost exactly $1 billion.

Curiously, the national valuation of the gold reserves hasn’t risen much — from $734.7 million in December to just $804.2 million in February. Which implies that the huge jump in gold reserves might just be some kind of data-input error. But on the other hand, it coincides exactly with Ecuador’s decision to default on its foreign debt. Might the Ecuadorean central bank be trying to convert attachable assets into something it can safely store at home? And if the country’s gold reserves have soared this year, why hasn’t Ecuador’s valuation of those reserves increased proportionally? It’s all most peculiar.

Update: The IMF says that indeed this is “a simple data mistake that is being corrected”.