Tuesday, November 28, 2006

We're not going to pay!

Reader HFT asked me about Ecuadorean bonds, so here are my thoughts. First, some background.

Rafael Correa is now claiming victory in Ecuador's presidential election, and has threatened to default on its foreign debt. As ___ from the University of Sussex said in today's WSJ, "Correa wants to press the reset button on Ecuadorean politics..." He is also looking to rewrite the Ecuadorean constitution.

The CDS market for Ecuador is gapping, and is now over 500bps up from 250 at the beginning of the month. According to Bloomberg, that level is wider than Lebanon or Iraq. Now, I'm not an EM trader so I cannot give much insight into whether 500bps represents a buy or what. But its interesting to contrast this situation with that of a regular corporate bond default.

When a corporate bond defaults, bond holders have a legal right to the defaulted company's assets. In a simple situation where bond holders have the only claim in bankruptcy court, bond holders could choose to become the new equity holders of the company, or else could choose to liquidate the assets and take what recovery they could.

The situation with sovereigns is far more complex. There is no legal authority to force a sovereign to pay their debts. When you lend money to a nation, you are really at their government's mercy. The only incentive nations have to pay debt service is continued access to debt markets. As soon as a government hints that it might not repay its debt, the spigot from foreign investors goes dry.

Curious then that the apparent new regime, which has an ambitious social agenda, is so willing to poison the foreign debt well. I read pieces from Citigroup and Merrill Lynch, both saying that Ecuador is in such good fiscal shape that a default would be an odd move. So maybe its all saber rattling. Maybe its Correa's way of communicating to the public just how sweeping his plans are, even if some of the elements of the plan aren't implemented. Who knows?

The question for investors is do you really want to bet on this guy? Just as Europe is starting to realize how bankrupt an idea socialism is, it seems that Latin America is renewing its fascination. Does Correa not realize how fungible capital is today? Does he not see that foreign manufacturers currently operating in Ecuador could move to India or China or Singapore in a heartbeat? Why does he want his country to look more like Cuba and less like Mexico?

For my money, the spread on Ecuadorean CDS could be 1,000bps, I'm still staying away.


HFT said...


Anonymous said...

Who needs the debt markets when Uncle Hugo is handing out gifts to all his friends? And of course, oil prices can only go up.
But if you don't like the president of Ecuador, don't worry. A new one will be coming along any day now.

Accrued Interest said...


I don't think the idea that Chavez will always be there to bail you out is good economic policy.

Whenever I hear about a country electing some ultra-leftist populist like Correa, I feel like I'm back coaching 7-8 year old baseball. You keep telling the kid to watch the ball and keep his glove up when he's trying to catch it. And it seems like he gets it. Then when you actually throw it to him, he turns his head away and winds up getting hit by the ball. You'd think the other kids watching would learn from the first kid and not turn away, but no. Most of them get nailed too.

So it seems to me that Ecuador was sitting there watching Cuba, Russia, and Venezuela get hit by the ball over and over. Yet still they want to have a go at socialism. What can you say?

Alright Correa, here comes the ball...