THE D WORD

As of this week the Lehman emerging markets bond index was down over 28% for the year, with the Latin America and European sub indices each down by an even larger percentage. Pummeled by falling commodity prices and without the ability to borrow any more from external markets, the emerging economies are in dire straits and the potential for default by one or more of them has become very real.

Two countries that our customers have asked us about repeatedly this week are Argentina and Russia. The prospect of default by either is significant: after years of misguided policy Argentina’s government is genuinely broke, while Russia’s potential for reneging on its obligations may be motivated by politics as much as its balance sheet.

Argentina: Sinking Fast

Compared with the other major Latin American economies there are relatively few tranches of Argentine US dollar denominated debt, most of which was issued in the wake of the default through rolling existing bonds. Despite this, external debt still hovered at just under 50% of GDP in the first quarter.

Raising money in international markets has been difficult for Argentina’s leaders since they still have not fully settled with creditors in the 19 country Paris club –their primary new foreign creditor in recent years has been the Venezuela Government (with Comrade Chavez demanding yields as high as 15%). Early in September President Kirchner announced that she intended to attempt a settlement on the $6.7 billion remaining in defaulted debt at the expense of the nation’s foreign currency reserves, but by then the credit markets had already shut down completely. This leaves her with only the home market left to turn to as she seeks to salvage her ambitious public works programs.

The private pension funds that are currently being eyed for nationalization are among the primary holders of Peso denominated Argentine debt, as well as banks and other financial institutions. Many of the bonds held by domestic holders have yields linked to inflation, which has become a source of controversy since the present administration and its predecessor adopted a policy of publishing fake, artificially low CPI numbers to stave off additional interest obligations. This policy of lying contributed to additional tension between Argentina and the IMF, helping to make the chances of international aid even more remote.

In short, the policy restructuring of domestic debt and nationalization of pensions that the government has embarked on seem likely to undo all the progress made by the Argentine economy over the past 5 years within a few short months.

The Peso’s plunge and skyrocketing yields (see chart below) indicate that foreign traders have largely factored a restructuring of some type in already. At this stage, the impact of a default will for the most part only be felt by the Argentinians themselves and their immediate neighbors.

Russia: Wounded Bear

In comparison to Argentina, the Russian debt situation is infinitely more complex and greater in scope.

In recent years the Eurobond and other international markets were increasingly significant providers of liquidity for the Russian economy until the one two punch of the Georgia incursion and the banking crisis effectively closed those windows. As such, the current bailout plans being sponsored by the Russian government has been financed domestically –with domestic Ruble debt there up over 10% YTD as of the end of September. With the freefall of both the Ruble and oil continuing to pick up speed, the Kremlin has adopted a consistently more aggressive tone.

If you read our work regularly you know that we view the economic crisis facing Russia and its political allies as a very serious issue that could have a destabilizing impact on global politics. Putin & Co. have a record of seizing private assets whenever it suits them, this does not bode well for creditors –the current turmoil could prove to be an irresistible opportunity to take Russia back into bankruptcy and rebuild it according to their vision.

One clear loser in any Russian debt restructure would be EU unity. A passive response by large economies there with more skin in the game will be perceived as appeasement by their newer Eastern partners who retain a profound distrust of their former overlords.

We will be keeping our eye on Russia and Argentina closely for the foreseeable future. Unlike some well known market pundits however we will not be making any investments there; assets could not possibly be “cheap” enough for us to want to own them in a nation so poorly managed as either.

Andrew Barber
Director