2005 FALL FORUM
EMTA Fall Forum Panelists Debate whether External Debt Over-Valued, Interests in Local Instruments Justified
EMTA’s Fall Forum on October 6, 2005 attracted a crowd of 125 attendees despite market volatility and an EMBI+ widening of 20 basis points. The event was held at the offices of UBS Investment Bank in midtown Manhattan, with many in the audience seeking commentary from market sages on the recent sell-off.
Moderator Michael Gavin (UBS Investment Bank) prefaced the Forum’s panel discussion by explaining that each speaker had been pre-assigned a bullish or bearish position on various topics, which did not necessarily reflect the speaker’s own opinion. Turning immediately to the subject on everyone’s mind, Gavin requested that the panel debate whether Emerging Market external debt was over-valued. Guillermo Mondino (Lehman Brothers) and Amer Bisat (Rubicon Fund Management) were selected as bears, while George Estes (GMO) and Paulo Vieira Da Cunha (HSBC) were asked to present the bullish viewpoint.
Estes asserted that "last week clearly the market was over-valued when the EMBI+ spread reached 235; but this week above 250, I would say the opposite." He argued that the general narrowing of spreads in the asset class in recent years has been based upon four factors: (1) global economic conditions – low interest rates, low inflation and "pretty good growth in the US and other countries," which has translated into strong demand for emerging country exports; (2) specific economic conditions in emerging countries, e.g., high commodity pricing, economic growth, and current account surpluses; (3) market conditions in the asset class, with new money continuing to enter while the amount of leveraged flows is less than in the late 1990s; and (4) the economic policies being carried out in the emerging world, such as the adoption of flexible exchange rates, liability management operations, greater fiscal responsibility and the completion of 2005 financing needs by many sovereigns, with many also tapping the markets for 2006 pre-financing.
Estes observed that some spread compression was strictly due to technical factors, such as the retirement of higher-spread Brady issues, and the Argentine restructuring, which itself led to a 50 basis point EMBI index narrowing. He also lauded increased market efficiency due to the growth in liquidity in the credit default swap, option and repo markets.
Vieira Da Cunha buttressed the bullish position by calling attention to the structural changes that have occurred in most of Latin America. He echoed Estes’ comments on rebounding economic growth and greater fiscal responsibility, while highlighting the improved credibility of many central banks and their increased ability to manage monetary policy.
Bearish Bisat expressed concern that some new investors in the asset class did not really understand Emerging Markets, noting that it should give long-timers pause when new entrants use the same convergence arguments that "we used to use twenty years ago." Bisat predicted that, "when they realize the volatility associated with Emerging Markets, they are going to run to the door, and today is a very good example." On a fundamental basis, Bisat pointed out that inflation is picking up globally while growth is slowing. If this trend continues, it will be a "disaster" for Emerging Markets.
Mondino disclosed that he was actually optimistic on the market’s long-term prospects, but, fulfilling his obligation to make the bearish argument, he criticized the market’s dramatic tightening in the previous month, describing it as hard to defend. September 2005 was a month of "normalization" of economic conditions after some macroeconomic "deteriorations" in the Philippines and Ecuador, rather than a month of progress that would have justified narrower spreads. Mondino reminded the audience that much of the compression has been described as a result of strong oil pricing, but cautioned that investors didn’t seem to be discriminating between those countries which would actually be helped by higher oil prices, and those which might be harmed. "Oil is a very powerful story for Russia and Venezuela, but it’s no longer a very powerful story for Colombia, much less for Ecuador, Indonesia, Brazil or Turkey," he stressed. He compared US AAA corporate bond prices to Russian sovereign debt and questioned whether money managers truly believed that the latter should be priced 55 bps tighter than the US prices.
Gavin next invited panelists to debate whether local instrument investment was the next "internet investment of the late 1990s" or the much-heralded "wave of the future."
Bisat, assigned the bullish position, argued that emerging sovereigns have accepted the "original sin" argument espoused by Professors Ricardo Hausmann and Barry Eichengreen, and that many are now moving to issue debt in local currency. These obligations are attractive to investors as real yields are still very high, because they continue to include an inflation volatility premium despite the fact that inflation volatility has actually declined. "Those who buy are saying ‘we believe in the credibility of the monetary policy makers; and we are going to bet that they are going to continue meeting their inflation targets well into the future’," he explained. In addition, bulls believe that emerging currencies are still quite undervalued.
Bisat added that there is a "fundamental paradigm shift"; policymakers have "bought into fiscal responsibility and monetary policy credibility, and there is no reversibility of those policies." He concluded that "this is the only asset class that is impervious to the sudden and certain slowdown in global growth."
Estes threw cold water on Bisat’s enthusiasm by countering that local instrument buyers are merely assuming the "original sin" risk from the issuer. He cited custody issues, taxation issues, and a possible change in the regulatory environment as other reasons to reconsider the local debt craze. "In contrast to the developments in external debt, in local markets you have very wide bid-ask spreads," he warned, and added it is often difficult to finance or short local debt, or purchase derivative instruments. Estes concluded that countries have "two chances to default on local instruments…There is the regular default, i.e., not meeting payment terms, and in addition you have devaluations."
Mondino responded that market risks in local markets were diversifiable. The strong correlation between local market debt and credit means that, most of the time, credit instruments can be used to hedge local market risk. He added that the counterparty risks one has in the local markets today are the same risks one has in the external markets, since local pension funds and local asset managers have increasingly become external debt owners. He questioned greater investor comfort with debt governed by foreign law, commenting, "what we have learned with the Argentine default is that the value of international courts as a mechanism to protect creditor claims is not as great as we had originally thought it was." Mondino acknowledged that local markets might be a "fashion or a fad," but as the multilaterals are now convinced that the resolution of "original sin" will add stability to emerging economies, these countries will increasingly issue local debt.
Vieira Da Cunha was allowed the final "bear" rebuttal. "The danger, of course, is that, if push comes to shove, you can inflate that debt away. So the question is, can investors effectively and economically hedge their currency exposure?" Because of incomplete markets, they are often not able to do so, or they have to "pay through the roof" to offset local currency risk, he asserted.
Gavin solicited panelist feedback on how far the search for return in local markets could go. Bisat responded that "there is a massive information failure in many exotic countries such as the Dominican Republic, Egypt, Mozambique…but a little bit of digging can buy you quite a bit of value" if one is willing to go through the documentation. He advised that, "precisely because no one looks at some of these countries, they can be extremely attractive and good diversifying tools."
The panel took a number of questions from audience members. Prompted to estimate the return for EM debt over the next year, Bisat predicted 6-8% for external debt and possibly double digit returns in local Turkish, Argentine and Brazilian debt. Mondino seconded Bisat’s 6-8% forecast on external debt, and recommended Argentine, Brazilian, Venezuelan and Turkish debt. Vieira Da Cunha suggested that Mexico should appeal to investors who think US Treasury bond prices will rise and oil prices will fall, but recommended Brazil, Colombia and Peru for those expecting the current economic climate to persist. Estes declined to provide a specific forecast, but believes that over the longer term Emerging Markets debt will prove relatively attractive vis-à-vis other asset classes.
Finally, called upon by a fellow panelist to offer his assessment of Mexico, Gavin remarked that "the risk of political noise [from the upcoming presidential race] is very high in Mexico, but the fundamental political risks are relatively low." He noted that in 2006 watching the presidential race will be a market "obsession," and, although the race is likely to be a close one, voters will ultimately not support "changes in the political framework that will worry you." A contested election result is possible, but he suggested this would likely prove a buying opportunity.