When Markets Take Fright

There is not much anyone can do when investors suddenly turn and charge in great herds. Markets have trampled over Brazil twice in four years. In 1999, investors dumped the real, Brazil’s currency, forcing President Fernando Henrique Cardoso to let it float in spite of winning International Monetary Fund loans worth $41 billion months earlier. The real quickly sank, losing one-third of its value against the dollar in a few traumatic weeks.

“If you ignore markets and they are negative, they will run you over,” comments Brian O’Neill, head of Latin America at JP Morgan. Walter Appel, a director at Banco Fator in São Paulo, says, “We are in what I call a ‘bad news cycle’ where all news is considered bad and even when it is not necessarily bad it is interpreted in a negative way.”

Investors this year have sold billions of dollars-worth of Brazilian bonds, driving up the spread of Brazilian bonds over US Treasurys to 2,000 basis points and more. The real has lost another 30% of its value so far this year. Fear that a left-wing candidate will win next month’s presidential election, careless talk in July by US Treasury Secretary Paul O’Neill, an outbreak of risk aversion in the developed world, a credit crunch and creeping contagion from Argentina have converged to create a crisis the like of which markets have not seen for decades.

The head of fixed income trading at a big New York brokerage comments that, “There is fear that there is more, a lot more downside than there is upside because even if [the government] still wins the elections, confidence may still not come back. There will be no refinancing and we’ll all be doomed.” Most investors called Argentina’s 2001 default months ahead of time and were able to avoid big capital losses. Having escaped Argentina, they don’t want to get crushed by Brazil’s government, which owes $287 billion to local and international investors.

Fundamental Strengths
Yet Brazil’s economic fundamentals have deteriorated. This, the real’s depreciation and base interest rates of 18% a year have driven the government’s debt-to-GDP ratios close to 60%. The August agreement with the International Monetary Fund, which threw the government a $30 billion lifeline, enabled the government to try and calm the markets. Asset prices continued plunging, indicating a 35% probability of default in the coming 18 months for Brazilian debt. This is close to becoming a self-fulfilling prophecy as investors sell assets at distressed prices, triggering a further round of price declines. Each percentage point fall in the real’s value against the dollar drives Brazil’s total debt up by $1.4 billion. Only 11% of the domestic debt is at fixed rates. The rest is tied to the overnight Selic rate or the exchange rate.

Richard Madigan, head of emerging market sales at Barclays Capital in New York, noted in July that, “Secondary-market turnover across emerging market debt is averaging $750 million per day against a normal $1 billion to $1.5 billion.” Worryingly, local asset managers have not been buying up bonds on the cheap as foreigners flee – partly because they too are worried about a repeat of Argentina’s debacle and because their clients are smarting from new mark-to-market regulations for fixed income investment funds. In the US, asset managers, fearing a rising volume of redemptions, have had to remain highly liquid or sought out less volatile safe harbor credits like Chile or El Salvador.

The bond market began cooling on Brazil only recently. After all, the country was able to borrow $12 billion on the world’s debt capital markets in 2001, its busiest year since 1997. The country raised two-thirds of this money in the first half of the year. In comparison, issuance in the first half of this year had fallen to $6 billion, one-third less. Brazil’s last big issue came in April, when the sovereign struggled to place an eight-year, $1 billion bond yielding 12.77%. Bookrunners Morgan Stanley and JP Morgan had to face a market laden with recent Brazilian issues. Investors often complain that Brazil prices its bonds too aggressively, and doesn’t leave room for much post-launch upside. This time, though, Brazil only sold its bonds after it widened the spread by nine basis points to 719 basis points over comparable US Treasurys.

There is no investor appetite for plain vanilla bonds, at least not at a price issuers can afford. A few commercial banks have tapped the market since then but only by using collateralized bonds wrapped with political risk or financial guaranty insurance (see Securitization, The Securitization Lifeline). Even so, this is a market restricted to a few blue chip names and is limited by capacity in the insurance and reinsurance industries.Refinancing risk is very high, and weaker companies are unable to renew loans on reasonable terms.

Ever Uncertain
Even if the government scrapes through the year without defaulting on its foreign bonds or imposing a forced restructuring on its domestic creditors, the outlook for the years ahead is uncertain. Fator’s Appel says, “Why should a foreign investor roll over Brazilian debt? This may not be a problem this year, but how about next year? In the next 12 months everyone holding Brazilian paper will want to get paid.”

There is a possibility that the US will face another economic slowdown. Stephen Roach, Morgan Stanley’s influential chief economist, commented in August that, “All it would take would be another shock to trigger [a] double dip. Several such possibilities concern me – intensified corporate cost-cutting that triggers a new round of layoffs, a credit crunch, a downturn in housing markets, and another geopolitical shock. Just as it was the case in late 2000, it wouldn’t take much to push a stalling US economy over the brink and back into recession.”

If he is right, Brazilian issuers could have to wait quite a while before they can refinance their maturing debt loads, let alone raise fresh debt on international markets. This assumes a smooth political transition in Brazil this year and that the next government is committed to pursuing coherent economic policies and is able to implement these policies effectively. A prolonged lenders’ strike would inexorably force Brazil to default. Brazilian borrowers have $34 billion in bonds maturing over the next five years and two-thirds of this money is owed by the federal government and public sector companies. Next year, an aggregate $5 billion in bonded debt falls due, followed by $8 billion in 2004. In addition, companies and banks have $2.35 billion in loans due next year and $3.34 billion in 2004.

These sums are not trivial, but they are manageable in a stable environment, but market instability is putting companies under pressure and there is bound to be an increase in debt restructurings in the corporate sector. A default by the government would be a disaster for everyone. Brazil could find itself shut out of the voluntary debt market for years.

However, Brazil has always been a large and attractive market for Wall Street. Stephen Cunningham, head of Latin American investment banking at Morgan Stanley, says, “Because of its dynamics and strength, I really do maintain that Brazil is different.” He says Brazil has a skilled financial team at the central bank and finance ministry, and with the time they have left, still have a large arsenal of market and policy instruments to “work with a lot of creativity on the domestic debt.” Dan Vallimarescu, Merrill Lynch’s head of debt capital markets for Canada and Latin America, says, “Brazil is a huge, dynamic powerhouse market that will not disappear off the radar screens.” Even a hard-bitten professional like Appel is fundamentally optimistic about Brazil: “2003 will be a difficult year whoever becomes president but 2004 will be a good year.”