The world faces the worst financial crisis for decades, yet only one emerging market sovereign has so far entered default. But untested new issuers, political risk and the persistent lack of agreed restructuring mechanisms mean sovereign debt is still far from a risk-free investment. Writer Philip Alexander.

In 1982, they were called less-developed countries, and they almost plunged the US banking sector into insolvency. By the 1990s, they had been rebranded as emerging markets, but some things hadn’t changed. The Tequila Crisis in Mexico in 1995, the Asia Crisis in 1997 and the Russian Crisis of 1998 – in each case, the meltdown of emerging market sovereign balance sheets spilled into developed markets.

A decade after the Russia default, the world is gripped by what is increasingly billed as the worst financial crisis since 1929. But as US banks fall by the wayside, what of the sovereign casualties? So far we have seen only the tiny tropical island of the Seychelles, failing in July 2008 to make payment on a E53m privately placed loan note, which could trigger a cross-default on its $230m global bond. This is not exactly the kind of event to provoke contagion.

It may be too soon to give emerging market sovereigns the mantle of safe haven, however. Although resilient in the first months of the credit crisis, spreads on sovereign bonds have widened sharply more recently.

“There has been more focus on the fundamental components of sovereign risk in the past three months – geopolitics and global recession, the macroeconomic risks as well as problems in the financial system,” says Marc Lewell, head of emerging markets fixed income syndicate at JPMorgan. Outflows from emerging markets in 2008 hit their highest levels since the Tequila Crisis.

But the absolute scale of flows into emerging markets in recent years has been much greater than in the 1990s. There is general consensus that sovereigns are fundamentally more resilient after several years of better fiscal management and the build-up of foreign exchange reserves, enabling them to stay on the sidelines of today’s troubled credit markets.

“There are very few frequent sovereign debt issuers in the non-investment-grade world now. It is really only issuers such as the Philippines, Indonesia and Turkey, who have all very much established themselves with the global investor base,” says Mr Lewell.

Inexperienced issuers

However, the availability of capital prior to mid-2007 also tempted a number of new sovereigns into the market. The Seychelles default serves as a warning over the perils of poor-quality debt management, especially at a time when global markets have turned so hostile. Even after the credit crisis began, bond fund managers keen to diversify exposure snapped up debut Eurobonds from Ghana and Gabon in late 2007, and Georgia in early 2008. Belarus, Azerbaijan and Kenya have all mandated banks to prepare issues. Georgia was quickly hit by the conflict with Russia in August this year – spreads are now about 300 basis points wider than when the bond launched.

Still, Mr Lewell points out that such countries have not inherited large amounts of outstanding commercial debt, compared with the issuers of Brady bonds in the early 1990s. “Almost all the new issuers in recent years were people who, by definition, had no other sovereign debt outstanding. If you only have one public bond deal, and it is a 10-year deal, you don’t really have much debt management to do until it approaches maturity,” he says.

Derrill Allatt, head of sovereign advisory services at investment bank Houlihan Lokey Howard & Zukin, says that infrequent issuers still need to pay attention to their debt management. “We generally discourage bullet repayments that create a spike in their repayment profile. Sovereigns could find it difficult to refinance,” he notes. Houlihan Lokey advised Belize on how to restructure its debt after the sovereign ran into trouble over just such a bullet repayment in 2006. In practice, Eurobond issuance fees can also be prohibitively high, and smaller borrowers may find it more cost-effective to tap a loan syndicate instead.

Mahmood Pradhan, assistant director in the IMF monetary and capital markets departments, says the Fund broadly regards access to capital markets as a healthy sign of progress and investor confidence. “We are, however, mindful that it should not become excessive and threaten macroeconomic stability, and we are closely involved in surveillance and technical assistance to help ensure prudent debt management and offer advice on the terms of borrowing available,” he explains.

Politics still key

However, the turbulence faced by investment-grade Russian bonds and speculative-grade Georgian bonds alike is a reminder that politics remains the distinguishing risk for sovereign finances. “Investors remain fearful of political issues that take them back to an earlier era, where there was a weaker macroeconomic policy environment,” says Mr Pradhan, who rejoined the IMF in 2007 after a decade as a macro strategist for hedge funds including Tudor Investment Corporation.

In Ecuador, hydrocarbon exports have given the government the means to pay. But investors are waiting to hear more on president Rafael Correa’s commission to decide if its external sovereign debt is legitimate, says Stuart Culverhouse, chief economist of emerging market illiquid securities brokerage Exotix in London. The commission was due to report in July 2008, but so far this has not been published, and the president has not repeated earlier threats to repudiate the debt.

Meanwhile, political turmoil in Pakistan aggravated a stock market crash earlier this year, and a highly expansionary fiscal policy has sucked in imports, leaving less than $7bn in foreign exchange reserves. Now the country faces a Eurobond redemption in February 2009, which gives the new and potentially fragile coalition government very little time to begin a policy correction. “The new president is likely to get support from the US and other key donors to tide Pakistan over for geopolitical reasons, but it is a very narrow path,” says Mr Culverhouse.

The lessons of Argentina

The elephant in the room in terms of politics and sovereign defaults, however, is Argentina. In 2005, the country imposed a non-negotiable restructuring on the holders of bonds that had defaulted in 2002 after the latest in a long list of financial crises. Bondholders with debt equivalent to about $20bn, including many retail investors in Italy, refused the offer of 30 cents on the dollar. “Another 10 cents, and they could well have cleared the market, taking out at least 90% of bondholders, instead of 74%,” says one of those holdouts.

Since then, lawsuits brought by specialist distressed debt hedge funds have been grinding their way through courts in the US and elsewhere, gradually raising the pressure on the government to compromise. In September 2008, a US court ruled that one of the largest and most experienced holdout funds, Elliott Management, could attach assets from the state-owned Banco de la Nacion as payment for the money it is owed, because the government used the bank so extensively as a policy tool that it was legally an ‘alter ego’ for the sovereign. If Elliott is successful in a similar case involving the Argentine central bank, this could have wider ramifications for the country’s financial policy.

In theory, the law governing the 2005 exchange forbids reopening the tender before 2010. In practice, however, the Argentine government has shown itself willing and able to change the law when it suits its own purposes, says Jay Newman, fund manager for Elliott Management. “President Cristina Fernandez has just submitted a bill to congress that would allow her to draw on central bank reserves to pay off the Paris Club,” he notes.

However, fund managers suggest that Argentina could be the last hurrah for distressed sovereign debt investing. Many of the remaining defaults are in genuinely poor countries, often emerging from years of conflict, such as Liberia and Côte d’Ivoire. Even leaving aside the moral issues, there is no real investment case for litigating against such countries, as recovery prospects are very limited. After substantial official debt relief, the London Club of commercial creditors agreed a deal with the government of Nicaragua in December 2007, which returned the equivalent of just 4.5 cents on the dollar.

Even where the means to pay is stronger, protection for creditors has been significantly eroded over the past decade. In particular, most sovereign bond issues now include a Collective Action Clause (CAC), which requires a large majority of bondholders – typically at least 75% – to start recovery proceedings in the event of default.

The bondholders would then have to instruct and indemnify the issue trustee, but bank trustee departments are rarely equipped to run legal actions of this sort. “Even if they manage to get a judgement, they are unable to pursue enforcement, which is a very expensive, labour-intensive business with a high premium on creativity,” says one fund manager. In these circumstances, he warns that 20 cents on the dollar could be a good result in terms of recovery on future sovereign defaults, if other countries chose to echo Argentine belligerence.

New faces at the table

Those working for the issuers, however, argue that CACs are essential to a well-functioning market. Mr Allatt at Houlihan Lokey says that the CAC makes it easier to resolve a default once the “super-majority” of 75% or more is reached among creditors, rather than allowing one bondholder with a few per cent of the total to obstruct the deal.

The Belize restructuring, finalised in February 2007, was the first in the New York jurisdiction to involve bonds issued with a CAC, and it had taken less than seven months from announcement to completion – compared with the seven years during which much of Latin America was in default in the 1980s.

The creditors affected by the Latin American defaults in 1982 were a small group of commercial banks, but recent restructurings were dominated by more numerous emerging market bond funds or hedge funds. For these funds, the bond itself is the only source of value, whereas banks might have one eye on repeat business with the government.

However, Thierry Desjardins, senior vice-president of debt restructuring at BNP Paribas and a co-ordinator for many London Club creditor committees since 1993, says he has yet to witness any profound clash between banks and funds. “I have not faced pressure from my colleagues. We have the same goals as the funds. What we all care about is getting the right value in the restructuring, and I have not heard complaints from funds when we work together in creditor committees,” he says. And Spencer Jones, managing director in Houlihan Lokey’s sovereign advisory team, says the adoption of mark-to-market accounting by most funds has encouraged them to reach speedier agreements.

Of more concern to all is the growing number of less experienced creditors whose behaviour in restructuring situations has yet to be tested. As some emerging markets themselves build up massive foreign exchange reserves, they have stepped up lending to some of the least developed nations: so-called south-south investment flows. Mr Desjardins says the London Club has already received requests from some Chinese banks to be included in certain creditor committees.

Mr Allatt believes sovereign borrowers stand to benefit from a greater variety of funding sources, but he notes the urgency of integrating new nations into organisations like the Paris Club of official creditors.

“We do not yet have a forum for borrowers to bring these new creditor nations together, which means there is a risk of having to conduct many separate negotiations to reach a deal for debt rescheduling,” he says.

Playing by the rules

In a bid to develop formal guidelines for sovereign debt workouts, the Institute for International Finance (IIF) last year brought together creditors and official borrowers to produce a set of principles. Mr Allatt was a member of the advisory group that helped devise these, and he advocates to his sovereign clients that they negotiate in good faith, with full transparency about their financial position. “This is essential to convince creditors that the debt restructuring is needed, and that they won’t come back asking for another rescheduling later,” he observes.

However, Mr Newman is sceptical that guidelines alone will encourage co-operation unless the framework has teeth to protect creditors from imposed restructurings. “Best practices start with government responsibility, they have to honour their obligations to develop capital markets,” he says. Defence lawyers for defaulted sovereigns, especially Argentina, have attempted to build a body of law that would make enforcement against sovereign debtors more difficult. Mr Newman is concerned that such efforts could, over time, lead to lower willingness to lend and higher borrowing costs for sovereigns, which would not be in the interests of the emerging economies themselves.

Those risks should give borrowers enough incentive to maintain constructive relations with creditors, says Mr Pradhan at the IMF. “If there is a dispute, there can be large economic costs far beyond the cost of litigation. You will pay more in spreads, in trade financing, and in the duration of financing,” he notes. Bankers who work with other sovereigns on debt management also confirm that, with the possible exceptions of Ecuador and Venezuela, many emerging market finance ministries are privately appalled by Argentina’s repeated alienation of creditors.

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