Third World debt: what next?  

THE trillion dollar emerging market debt bazaar arose in the aftermath of the Third World sovereign loan crisis in the 1980s. It is one of the world's most successful experiments in asset securitisation. Yet this complex global capital market has experienced three traumatic shocks since the first Brandy bond was issued for Mexico in the first Bush Administration.

In 1994, Mexico devalued the peso and the subsequent "tequila crisis" had a chilling effect on the international credit standings of all Latin American borrowers in the sovereign Eurobond markets. Clinton and his Treasury Secretary Robert Rubin bailed out Mexico with an IMF package but the crisis highlighted the contagion risk that exists in this asset class.

In effect, contagion risk means that a macroeconomic crisis in a major nation will have negative spillover effect on the debt, currencies and international credit rating of all emerging market borrowers.

The Asian currency meltdown and the Russian ruble devaluation in 1997-98 dealt a systemic shock to the emerging market debt market, as hot money from the West was pulled out at the worst possible time from Third World economy, mainly by leveraged and speculative hedge funds. However, as the market for Third World debt has grown and matured, it has attracted a new investor base, primarily institutions such as pension funds and high yield bond funds in the US. This has meant greater liquidity and lower transaction costs, the most valued component of any embryonic capital market. Ironically, this has also lowered the contagion risk in the emerging markets and the correlation coefficient among major financial indices and the Third World bond market and Nasdaq has not had a major impact on emerging debt this year. Nor did political crises in Taiwan or Pakistan and tense IMF negotiations with Turkey and Argentina create a contagion driven panic in the market. These are both unquestionably bullish indicators for the evolution of the asset class as well as its integration in mainstream institutional investor portfolios.

The fact that contagion risk has been low in 2000 does not mean that it cannot rear its ugly head again. Only a global panic and investor aversion to risk could cause another systemic crisis in the emerging markets. This would happen if the US economy goes into recession. However, while the economy is decelerating fast, there is no danger of a hard landing - yet. The arguments for a credit ease by the Federal Reserve are piling up with each new set of macroeconomic data. Retail sales and industrial production is slowing. NAPM has declined three months in a row. GDP growth in the third quarter is at its lowest in four years. The capital markets are in a mini-crisis, with Nasdaq down 50 per cent from its peak, the IPO window and high yield debt market have shut down for now, bank loan syndication volumes have halved, corporate credit spreads are at their widest since the Russian crisis.

It is not inflation risk that the Fed should worry about but deflation risk. With crude oil down sharply from its highs, PPI and CPI flat, a strong dollar and an inverted yield curve, I cannot see where the FOMC sees inflation risk. All this, of course, without the impact of the two trillion dollar equity wipeout on Wall Street since March on consumer confidence and spending. Net-net, the Fed has no option now but to signal an ease in monetary policy despite the tight labour market.

What does all this mean for the prospects for emerging market debt next year? A hard landing or a global recession is the worst case crisis. This is a low risk probability as it presupposes a Fed unresponsive to the credit crunch and economic slowdown as well as a dollar crisis that could ignite capital flows away from the US. It is far more likely that the global economy will slow but not slide into recession, as central bankers in the US and Europe cut interest rates as predictably as they raised them in 1999-2000. This macroeconomic scenario is generally positive for emerging market debt. Spreads on sovereign LDC debt over US Treasuries could shrink significantly in a soft landing scenario, offering the possibility of capital gains.

Apart from economic growth and interest rates, the other significant factor in emerging market debt is the sovereign credit rating cycle. Mexico was upgraded to investment grade by Moodys after the presidential election this past summer and it is likely that Standard and Poors will follow suit in the next few months. Both Brazil and Russia have made significant structural macroeconomic reforms and their international debt yields have fallen sharply in the past twelve months. Who would have believed that 2000 was a year when investors would have lost half their capital on Microsoft but doubled it on Russian debt? Naturally, emerging markets like Indonesia, Mexico and Venezuela have done well, thanks to high oil prices. Turkey and Argentina now have IMF lifelines in place and are committed to privatisation, labour and banking reforms.

There is no question that the systemic leverage ratios in emerging market debt have fallen, as peso, ruble and Asian currency crises of the 1990s are replaced by insurance companies and pension fund managers better capable of differentiating among paper to meet bankers margin call at the first hint of a crisis.

This structural shift in the market means that it will continue to attract investors in search of higher yields a time of moderate global economic growth, lower dollar interest rates and improved credit fundamentals in benchmark emerging markets such as Brazil, Mexico and Turkey.

The hard landing scenario of higher inflation, a spike in interest rates and global recession is not going to happen because the central banks are all too aware of the destructive potential of a credit crunch. Therefore, emerging market debt has the potential to offer a 20 per cent dollar return in 2001.

The opinions expressed by the writer are his own and not endorsed by Press Release Network.

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