Reining in Risk
Venezuelan President Hugo Chávez may scare the daylights out of the business Establishment with his leftist economic policies. But when his financial emissaries hit the road in early September to gauge investor interest in a new $500 million bond offer, the response was so enthusiastic the government successfully doubled the issue. Five years ago, Russia was the black sheep of global finance, after it defaulted on $43 billion in bonds. Today, Russian companies have little trouble floating paper abroad, and ratings agencies hint they may soon label Russia as an investment-grade sovereign risk. Just a year ago, doomsayers predicted Brazil could not avoid financial catastrophe even if it got another rescue package from the International Monetary Fund. But on Sept. 10, Brazil easily raised $750 million -- in its fourth bond issuance this year. It's a similar story in Indonesia, another former pariah.
The long drought in emerging-market debt issues is over. This year, developing nations are on track to raise $32 billion in foreign bonds, says the Institute of International Finance (IIF), a Washington think tank. That's still well below the heady levels before the 1997 Asia financial crisis but more than twice as much as 2001 and 2002 combined. Despite a sell-off when U.S. rates spiked this summer, the spreads above U.S. Treasuries for sovereign issues by the 32 nations in the J.P. Morgan Emerging Markets Bond Index are near their lowest levels since 1998 -- around 460 basis points. Even Western banks, which since 1998 had pulled more money out of developing nations than they loaned them, are now pumping in new credit.
There are two ways to look at the resurgence in capital flows to emerging markets. One view is that investors, awash with liquidity at a time of rock-bottom global interest rates, are letting their thirst for high returns overwhelm their good judgment by buying riskier debt. It was just five years ago, after all, that meltdowns in lands such as Brazil, Indonesia, and Russia burned investors and creditors for hundreds of billions of dollars and sent the global financial system into convulsions.
Then there is the more optimistic view: that the financial environment is becoming much safer for emerging markets. Developing nations are in better fiscal shape, have more flexible currency policies, have beefed up bank supervision, and are more prudent in their borrowing. For their part, foreign creditors assert they have grown more sophisticated in assessing risk. "Countries have better policies and bigger cushions of reserves, while investors like ourselves have more information," says Mohamed A. El-Erian, manager of the $950 million Pacific Investment Management Co. Emerging Markets Bond Fund, which is up 38% in the past year. "This means investors now go more by facts than by emotions."
Perhaps the biggest change is that international bondholders are playing a more active role in crisis prevention. Before the 1990s, debt workouts were brokered mainly by the IMF, governments, and a few money-center banks. But by the early '90s, the situation had turned chaotic as countries from Indonesia to Russia flung open their doors to private capital. That put more debt in the hands of U.S. mutual funds, European pension managers, Japanese retail investors, speculators, and hedge-fund managers -- who were nearly impossible to identify, much less organize. The system became so unstable that the IMF and U.S. Treasury, among others, pushed for a new international legal framework, similar to Chapter 11 bankruptcy in the U.S., to allow shaky countries to restructure debts.
Bitter opposition by Wall Street, which feared handing too much power to the IMF and making it too easy for countries to default, killed that grand proposal. But bond issuers and traders have since embraced other crisis-prevention measures. Most new emerging-market bond issues, for example, now contain "collective action clauses" giving governments and as few as 75% of bondholders power to renegotiate payment terms if a country is close to default. Incoming European Central Bank President Jean-Claude Trichet and other influential financiers are advocating a "code of conduct" under which distressed countries, the IMF, and creditors would pledge to renegotiate debts. The goal is to "create a better system for containing a crisis at an early phase, before confidence has already evaporated," says Managing Director Charles H. Dallara of the IIF, whose 300 members include the world's biggest commercial and investment banks.
One encouraging sign of cooperation: the surprisingly calm manner in which the Uruguayan government and a far-flung group of foreign bondholders averted default in May by agreeing to extend payments for five years. "Six months ago, if you asked if it was feasible for a country to get real debt relief from creditors without staring at a default, people would have said: 'No way!"' says attorney Lee C. Buchheit, a debt-workout veteran who represented Uruguay.
It is striking that, for the first time in six years, the IMF and World Bank will hold their annual meeting -- in Dubai on Sept. 23 and 24 -- without having to address some raging crisis. Even the $140 billion default in Argentina, the biggest flash point until it negotiated a three-year IMF program on Sept. 10, has done little to rock global markets. "Normally with events like those occurring, other emerging markets would be shut out from raising money," notes Philippines Finance Secretary Jose Isidro Camacho. "But we were not shut out." To finance its fiscal deficit, Manila has raised $1.7 billion this year and plans to borrow up to $250 million more. And in July, investor interest in a $500 million issue by the Philippines' National Power Co. was so strong it hiked the offer to $750 million, priced at 461 basis points over U.S. Treasuries.
Some analysts say the risk of a widespread financial contagion is abating. That's not to say individual economies won't keep imploding under unpayable debts and bad management. And if a major shock hits the U.S. or Europe, markets from Singapore to Santiago will suffer. What does seem to have receded, though, is the danger of a worldwide panic in which a currency crisis in, say, South Korea, prompts investors to yank billions out of other emerging markets without regard to financial fundamentals. Such crises were common in the '90s, triggered by currency crashes in Mexico, Russia, and Thailand. "This type of contagion has died down tremendously, and that is one of the great achievements of global finance," says Gerd Hausler, IMF director for international capital markets.
Should investors and developing nations breathe easy? Not quite. A big test of confidence will come if U.S. interest rates keep rising. That could improve returns available on American assets -- and trigger a retreat from riskier markets abroad. Indeed, the IMF warned on Sept. 9 that a swift drop in spreads, which are near historic lows for nations as disparate as Egypt, Peru, and Ukraine, could signal that emerging bond markets are "vulnerable to a correction." The IMF urges governments to press ahead with bank, tax, and spending reforms. And rather than exploit today's low rates to run up more debt, they should refinance older debt. "Global capital flows will remain subject to sudden stops because cross-border investors are fickle," says John Chambers, Standard & Poor's head of sovereign ratings. "You need a backup plan in case those flows shut down in two or three months."
So far, though, it's too early to say a bubble is building. Even with the recent surge of bonds and loans, overall capital flows into emerging markets will reach just $160 billion this year, predicts the IIF, half the annual levels of the mid-1990s. And much less money is in the form of short-term, high-interest, dollar-denominated bonds that can precipitate a crisis in the event of a currency devaluation. Instead, countries are mainly issuing foreign bonds with maturities of at least five years. "So there is less fuel for the fire," notes former IMF chief economist Michael Mussa.
Years of reforms have also left countries better able to cope with the demands of capital markets. Eastern European nations are conforming to Western economic and disclosure practices as they near entry into the European Union, for example. Since its 1995 peso crisis, Mexico has tightened public finances, curbed short-term borrowing, and nurtured a thriving domestic capital market. Once known for releasing sporadic or partial financial data, Mexico is now one of the developing world's most transparent borrowers. Its investor relations office posts weekly and quarterly data -- including off-balance-sheet items such as bank bailout costs -- on the Net and holds frequent conference calls with foreign investors. Mexico now boasts investment-grade ratings. Brazil Finance Minister Antônio Palocci credits investor outreach efforts, which included "hundreds of road shows, meetings, and seminars," with his nation's speedy return to capital markets. "The crisis last year was a crisis of confidence that was not justified," Palocci says. "This made us work more intensively to provide information on the real indicators in Brazil."
A shift to flexible exchange rates has also helped dampen the wild flows of "hot money." In 1996, virtually every Asian emerging market rigidly controlled its exchange rate. The huge, sudden surges and withdrawals of dollars, as lenders and speculators arbitraged global rates, led to currency crashes across the region. Finance officials either had to spend limited foreign reserves to support their currencies or let them slide against the dollar -- making it more expensive to service foreign debt.
Now, most Asian nations float their currencies. That discourages destabilizing buildups of short-term foreign capital. As money floods in, exchange rates rise. Then money flows back out. Mexico floated its peso in 1995. "The floating rate is a buffer that helps the economy absorb shocks," says Andrés Conesa, head of public credit at the Finance Ministry.
Emerging markets are also stronger financially. The foreign reserves held by developing nations swelled from $857 billion in 1996, or 4.7% of their gross domestic product, to $1.5 trillion today, or 7.8% of GDP. South Korea alone has $124 billion in reserves, more than twice its short-term foreign debt. In 1997, reserves covered 11% of short-term debt. Many nations have also slashed their foreign debt exposures. Russia's federal government debt plunged from almost 100% of GDP in 1999 to 36% last year. Since last year, the portion of Brazil debt denominated in dollars has dropped from 47% to 28%. And much less of it carries a maturity of less than one year.
Rising commodity prices are another factor. High oil prices are mainly why investors overlooked Venezuela's deep economic contraction this year. In February, Russian natural-gas producer Gazprom easily raised $1.75 billion in five-year bonds yielding 9.65%. "Gazprom could have raised much more if it wanted," says Jerome Booth, research director at Ashmore Investment Management, an emerging-market specialist. Russia's improved economy and improved governance under new Gazprom management also lured investors. Gazprom says it plans to raise up to $8.3 billion at home and abroad in the next four years to refinance existing debt and for expansion.
It would be a mistake, though, to assume emerging-market finance has entered some new halcyon era. The real gauge of how much creditors, governments, and the IMF have learned will come when the next debt bomb blows. Bonds with new collective-action clauses may help, but won't be widespread enough to make a major impact for many years. And the proposed "code of conduct" will be voluntary. Many investors burned in Argentina, Indonesia, and Russia remain fearful that, come the next real crisis, the IMF and influential institutions will negotiate rescues that protect their own interests but hurt small creditors. In Argentina, bondholders may have to absorb haircuts of at least 60%.
Even if no grand system has been devised to eradicate debt crises, there's agreement that efforts to contain the fallout are bearing fruit. Bondholders "now know the threat of defaults is serious," says Anna Gelpern of the Council on Foreign Relations. "But they also know restructuring is possible." If creditors can remain assured that the next blowup doesn't have to end in widespread disaster, there's hope that global financial markets will finally start fulfilling a promise: that investors will reward emerging markets that maintain discipline -- and punish only those that don't.
By Pete Engardio in New York, with David Fairlamb in Frankfurt, Geri Smith in Mexico City, Frederik Balfour in Hong Kong, and Jonathan Wheatley in Brasilia