Financial Times - September 27 1999
A new split is emerging By Edward Luce
Whether or not Ecuador defaults on its Brady bonds, the prospect has not led to a general sell-off in emerging market bonds.
One reason for this lack of contagion is the absence of any official statement from the International Monetary Fund. There is little point in the markets panicking until they know whether the IMF intends Ecuador to be seen as the first of many to default on its bond obligations or as a unique episode.
A second reason is that none of the other troubled emerging markets has significant obligations to the private sector. Those most likely to follow Ecuador down the road to default, including Pakistan, Moldova and Ukraine, owe almost all of their debts to official creditors such as the Paris Club and the IMF. Their bankruptcy would thus have little impact on the bond markets.
There is also a more subtle reason. In spite of the market's general wariness of riskier credits, investors have been differentiating more sharply between emerging markets in the last few months. Countries such as South Korea and Mexico are trading at spreads of 2-4 percentage points over US Treasury bonds, compared with spreads of 6-10 percentage points for Venezuela and Brazil. Russia, whose 10-year bonds yield 22 percentage points more than US Treasuries, remains in a league of its own.
Indeed, some economists, including Philip Poole at ING Barings, argue the term "emerging markets" has become irrelevant.
He suggests three categories: those whose economies are converging with the more developed countries, such as Mexico and Poland; those completely shut out, including most of sub-Saharan Africa, Russia and Ecuador, and those that have periodic but not guaranteed access to the international debt markets, such as Argentina and Thailand. Perhaps we should call them "converging", "submerging" and "waving but not necessarily drowning" markets.
Giles Keating, chief economist at CSFB, argues this division is likely to be more than temporary. Unlike previous recoveries, in which all emerging markets have tended to get lifted by the rising tide, Mr Keating says the next bull market will be different. This is because commercial and investment banks have sharply reduced their exposure to leveraged finance both through imposing tougher lending controls on hedge funds and by cutting down on proprietary trading.
A couple of banks have even hived off proprietary operations into separately capitalised vehicles. Others have imposed much stricter credit controls on emerging market dealing rooms.
The effect of this is to reduce the presence and influence of leveraged investors in emerging market debt and equities. This leaves the coast clear for "real money" investors, such as insurance funds and dedicated emerging market funds, to drive the market. The absence of leveraged investors - or the significant reduction in the amount of leverage they get access to - is likely to reduce the correlation in price movements between different emerging markets.
This is because leveraged investors tend to over-sell in a bear market to meet rising margin payments and over-invest in a bull market as margins fall.
No one is suggesting leveraged investors are out of the picture for good. And such safeguards tend to be circumvented when the markets are in a bull phase. But regulators are becoming much more vigilant in examining banks' exposure to funds. And hedge funds themselves are under much greater pressure to disclose their positions to creditors.
So what effect would a general shift in IMF policy have on emerging market prices? If Ecuador were presented as a template for future debt restructurings, all emerging markets would be hit. But some, such as Venezuela, would be more badly affected than others. And others, such as Mexico, would recover pretty quickly.
With yields relatively low in the developed economies and the pool of private savings in the west growing all the time, it is only a matter of time before funds start flowing back on a large scale to Mexico and other convergers.