As some of you may be aware, I was the keynote speaker at the 21st Annual Conference of the Association of Executives in Finance, Credit and International Business. I spoke on global trade and emerging markets, and the text of my keynote address is as follows:
Keynote Address of Robert P. Smith
FCIB’s 21st Annual Global Conference
Monday, November 15th, 2010 8:45-10:00 AM
Thank you for your kind invitation to speak here today. I feel particularly close to FCIB as I have been a member since 1983.
In those days there were maybe two hundred member companies, mostly based in the U.S. and Europe. Some of you might remember Gerd Peter Lotta who served as our Executive Director for many years and was an inspiration for all the members. In the early 1980s, of course, there was no internet and the financial markets weren’t nearly as technologically sophisticated as they are today. Communications were archaic by today’s standards. A lot of international commerce relied on the telex machine. For those of you too young to remember, the telex was a cumbersome affair: you keyed a message onto a tape that was then run through the machine for transmission to another telex machine across the ocean. Meetings were always held in London or Frankfurt.
How things have changed! FCIB’s membership now includes more than eight hundred companies from all over the world and meetings are now held in Asia and Latin America, as well as Europe and North America. Instant communication is the order of the day. The telex has been replaced by the Blackberry, e-mail, and pagers. The impact of the digital revolution on international commerce cannot be overstated. Indeed, my own business, trading sovereign debt, has been radically altered by the information technology revolution.
In my book “Riches among the Ruins: Adventures in the Dark Corners of the Global Economy,” I describe my adventures in the 1970s and 80s as a debt trader in some of the world’s most dangerous and financially risky countries. But some of those adventures started right here with FCIB.
Are there any of you over fifty who remember those days? Those were the days when foreign companies doing business in developing world countries had difficulty getting paid for their exports. They accepted as payment instruments such as El Salvador Reserve Bonds, Guatemala Stabilization Bonds, Turkish non-guaranteed trade arrears paper, Russian Foreign Trade Obligations, and Nigerian Promissory Notes. Can you raise your hands if you are familiar with these exotic instruments?
These sovereign bonds or trade obligations were issued by many so-called emerging market nations because these countries had very little hard foreign exchange — dollars or deutsche marks, or yen pounds. They imported far more than they exported and could not pay creditors in hard foreign exchange. So, as payment they issued bonds or other forms of debt, sometimes denominated in dollars and sometimes in their own currency. In the case of dollar denominated instruments, the risk was always: will the issuer make good on the promise to pay? In the case of local currency bonds, the challenge that typically faced foreign companies was how to repatriate local currency profits.
Let me give you a taste of what went on, from my book “Riches Among the Ruins”.
El Salvador, October 1984. It was gripped by a bloody civil war, one side was supported by the United States and the other side by the Cubans and the Russians.
Most of the fighting took place in the countryside, but the capital San Salvador was not immune from the violence.
I usually stay at the Sheraton Hotel but this night it was booked so I stayed at the Camino Real. I was nervous, not about the war, but I had just I had just purchased $4 million dollars Salvadoran dollar-denominated bonds which were bearer bonds like cash (meaning that they were payable to whomever got their hands on them). I had to deliver these bearer bonds to my buyer in San Salvador. I went to sleep early, placing the $4 million bearer bonds in my briefcase carefully under my bed, and fell asleep quickly dreaming of my profits the next day.
I was violently awoken at 3 A.M. by a huge explosion. Guerillas had blown up the Sheraton Hotel. Can you imagine if I had stayed at the Sheraton that night?
My bonds, for which I had mortgaged my house and body to the hilt, and into which I had put my entire savings, could have been burned up. Maybe I would have been killed. Not only would my wife have become a widow, she would have been a penniless widow!
Let me tell you how some of these transactions worked:
I had purchased those $4 million dollars of bearers bonds from a large English company in London. They had been selling their product in El Salvador but the Central Bank didn’t have enough hard currency to exchange its profits made in the local currency. Since El Salvador didn’t have enough dollars or pounds to do this, the English company accepted bonds payable in dollars. In other words, they accepted a promise to pay dollars in the future with interest. Often, a company like this English company doesn’t want to wait to get paid, especially if they’re unsure whether the bonds will ever be paid, so they were happy to sell them, albeit at a loss, and have no Salvadoran risk on their books. Better to have a dime today, they figured, than a dollar that might never be paid.
For every seller there is a buyer.
On the buy side in this case was a big American company in El Salvador. They, too, had made hefty profits in the local currency, colones, but since the government had no dollars to allow them to remit their profits, they bought El Salvador dollar denominated bonds from me. But they paid for them in colones, hoping that someday the bonds would pay off the principal and interest in dollars. In this case the English company was the pessimist and the American company was the optimist.
But now I had a problem. Colones were not of much value to me either, unless I could find a way to exchange them for dollars. My wife wasn’t going to be able to buy shoes on Newbury Street with colones!
In these bond deals I made far more colones than the Central bank would allow me to change into dollars. Remember, a lack of hard currency is why they were issuing bonds in the first place. So, I had to go to the black market and find a cambista or a moneychanger. I found Jose Manuel Gomez. I remember the first time I met him. I walked up some rickety old stairs to the second floor, and sat in his waiting room where he had a year old copy of Time Magazine, and waited to be ushered into his presence. The only thing he had was a pad of paper on his desk with a column on the buy/sell side, and three telephones.
I was about to hand over my total net worth to this man. I couldn’t ask him for a receipt and if he ran away with my money, I couldn’t bring a judicial proceeding against him in the local courts. He did change my colones to dollars although it took him ten days to do so. Unfortunately, Jose Manuel Gomez was murdered in 1988, some say by the military over a transaction gone bad.
Moving on to the main topic of my talk, I want to make three points here today:
First, I want to give you one excellent example of how poor decision making by lenders can set the table for the inevitable default of borrowers. I am not speaking of mortgage lenders in the United States! Rather, I am speaking of international lenders and debtor nations of the developing world,
Second, I want to describe the conditions and circumstances that threaten the careers of credit managers and other financial executives today.
And third, I want to make concrete suggestions on how to keep your credit portfolio from falling victim to the mistakes I have made or witnessed.
Countries Don’t Go Bust
or
Borrowing from Peter to Pay Peter
So, to my first point, many a lender to developing world nations has paid the price for believing in a simple myth: that countries don’t go bust because they supposedly can always tax their citizens to pay for their irresponsible borrowing.
After the 1973 oil embargo, countries such as Saudi Arabia, Kuwait and Qatar, built huge surpluses of dollars as the price of oil surged. Their economies couldn’t absorb these hundreds of billions of dollars, so the big oil exporters looked to invest the money abroad. Keep in mind that a billion then was whole lot of money, adjusting for inflation it would be the equivalent of almost 5 billion of today’s dollars.
The only place the oil exporters could think of parking such vast sums was the Eurodollar market; the market for US dollars on deposit outside the United States, typically in London, from which we get the famous LIBO rate. The banks taking these deposits were mostly American banks with familiar names like Citi, Chase and Morgan. There were also banks such as Manufacturers Hanover, Bankers Trust, and Chemical Bank whose names now might only show up in the TV series Mad Men.
Now, these money-center banks, as they were called, needed to find places to put this vast pool of money to work. Their traditional borrowers, America’s large corporations with strong credit, had abandoned them for much cheaper commercial paper placed by the investment banks. So the money center banks lent to lower quality domestic borrowers, like real estate developers and looked to find markets overseas.
The overseas markets available were not in countries like Germany or the United Kingdom. These countries had highly developed capital markets that allowed companies to borrow local currency and not have to run the risk of owing a foreign currency to a foreign bank. Rather, the money-center banks found eager borrowers among the developing countries such as Brazil, Mexico, Venezuela, Argentina and Nigeria. These countries had virtually no local capital markets so they were willing to borrow US dollars from the money center banks with floating rates of interest. By doing so, these borrowers ran the considerable risk of having to make much higher payments if interest rates went up or the dollar appreciated against the local currency. But this was a risk to the lenders, too.
The rationale for lending to these high risk borrowers was best expressed by Walter Wriston, CEO of Citicorp:
“Countries don’t go out of business….The infrastructure doesn’t go away, the productivity of the people doesn’t go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that’s very different from a company.”
Translation: “countries don’t go bust.” This ignores the fact that many of these same borrowers had a rich history of default going back to the 19th century. At the time this post-oil embargo lending began, these countries did not have much debt because the international bond markets would not lend to them in any significant amounts. But the money-center banks lent with abandon in dollars at floating rates.
By the way, In my talk I will refer frequently to Citibank; I don’t mean to pick on Citi. Actually, despite some flawed decisions, Citi was one of the better run banks whose actions were frequently imitated by other institutions.
The floating rate loans made by Citi & friends to the developing countries became much more expensive in the late 1970s as dollar interest rates began to rise. Higher interest rates contributed to a fall in the price of most commodities exported by these countries. One of the few commodities whose price did not fall was petroleum, which many of these countries imported. This perfect storm of adverse trends caused most of the developing nation borrowers to default in 1982.
The money-center banks were in a total panic over this colossal blunder. If they were forced to write down the value of these loans to their market value their entire capital would have been wiped out. For example, back in 1982 Citibank had about $5 billion in capital. Their exposure to Brazil was in the order of $5 billion and their exposure to Argentina was another $2 billion. Had they been forced to write these loans down to their true value the resulting loss from Brazil and Argentina alone would have been enough to wipe out their equity. Write-downs were not an option, so they worked closely with US authorities to paper over the fact that their capital had evaporated. To keep these bad loans afloat they began lending to countries like Brazil even more money, enough to keep the interest payments going for a while. Through such subterfuges they maintained the fiction that these loans were viable until 1987 when they had sufficiently recapitalized themselves to begin taking write-downs.
The trick of pretending to have capital when you are actually insolvent worked. The money-center banks were able to rebuild their capital during the booming 1980s and 1990s and get out of the hole they had dug for themselves. The banks were lucky because they used the trick of pretending to have capital during a time of extraordinary growth in the US economy; had they tried it during a less favorable time, such as now, the result would have been a lost decade for the US economy.
This analysis I gave you is completely post-facto. While we were living this situation very few people had the foresight to challenge the strategy pursued by these mighty banks. At the time, recycling of petrodollars seemed like a natural thing for the banks to do; not many people were even aware of the situation. Bad decision making by the banks created untold pain for the banks themselves and their borrowers. The banks lost huge amounts of investor capital and this loss no doubt prompted more than one consolidation or merger. The borrowing countries suffered even more, they were forced to devalue their currencies and drastically reduce the standard of living of their citizens. The default, and subsequent loss of access to any credit, contributed to many years of slow growth. All this pain and suffering served to create opportunities for people and companies that were nimble and able to take advantage of the paralysis of the big banks. That is how the trading of emerging country debt got started by a handful of people, including me.
One important lesson I learned from living through those tumultuous times is to be careful when liquidity abounds and interest rates are low because people make bad decisions under the influence of those powerful hallucinogens. Low rates and excess cash make the most hare-brained schemes seem plausible. The excess liquidity causes lenders to beat each other over the head to lend to dodgy borrowers. The low rates make dodgy borrowers look like sound credits. When the easy credit evaporates there is weeping, and wailing, and gnashing of teeth.
The story of the money-center banks and the pitfalls of excessive liquidity in the 1970s should sound very familiar. History has a way of repeating itself, which brings me to my second major point: the threat to credit managers and financial executives today. The financial meltdown in 2008 – the mortgage and credit crises – have all the same characteristics of the great money-center bank folly of the 1970s.
Credit Binge I – “My MacMansion is Bigger Than Yours”
After the 9/11 attack, the US economy nearly came to a standstill because of all the uncertainty created by the realization of how much damage could be inflicted by such a small group of attackers with few resources. The accepted response to sudden economic shocks is for the Federal Reserve to increase the availability of dollars, so the Fed pumped liquidity into a system that had discovered new ways to multiply money faster than ever before. The capacity to generate credit through securitization and the issuance of synthetic obligations that did not even require the existence of a willing borrower led to astronomic credit growth until 2007. During that heady time, countless decisions were made by lenders in states of consciousness thoroughly altered by excess liquidity and low rates.
All that easy money had to go somewhere. McMansions sprouted up everywhere, gold doubled in price, emerging market stock indices tripled in value, and the currency reserves of China and other emerging countries ballooned. The ride was exhilarating until the train jumped the track.
In 2008, we got another lesson about liquidity; just how quickly it can disappear. It seems that we had barely stopped using expressions like ‘wall of money” to describe the colossal flow of investor money looking for investments, when the entire financial system ground to a halt that fateful September. Remember how counterparties desperately tried to figure out whether they were dealing with a Lehman Brothers (a counterparty that failed) or an AIG (a counterparty that got rescued)? Remember how the commercial paper market, whose emergence did so much to drive the old money-center banks into their developing country follies, just ceased to function? Do you remember when congressmen were hoarding cash for fear the ATMs would run dry? Remember how New York City was suddenly eclipsed by Washington, DC as the financial capital of America?
As a result of the credit binge of the 2000s we are back again to the days of the banks pretending to have capital, with the full collaboration of financial authorities. The banks are still full of dodgy credits they cannot write down to their true economic value, so their capital ratios are all fiction. Financial institutions have wide latitude in valuing the credits in their portfolios and the crisis has actually resulted in even looser stands for asset valuation.
Credit Binge II – “Banks in Hell” – “Your Brain on ZIRP”
My understanding of the current situation in the banking industry is best illustrated by a grim fable. This guy dies and is sent to hell. The devil takes him to his punishment which is to be immersed in a large pool of filthy water where there are already hundreds of people standing with the water just below their lips. He hears a soft mumbling from the current occupants that he can’t quite make out. As he is lowered into the pool he finally understands what the wretches are all mumbling: “Don’t make waves, don’t make waves, don’t make waves.”
Well, after Credit Binge I the banks were up their very lips in liquidity, thanks to all the government intervention, but mixed in all that liquidity are some very dubious credits which make the banks afraid to make any waves at all. In this fable the capitalization of the banks, their margin of safety, is measured by the distance from the surface of the water to their lower lips. Being very thinly capitalized, they have very little room for any more mistakes in their portfolios, so they are hardly lending at all.
This, together with weak demand for credit among borrowers and the absence of the new money multiplier of securitization we talked about earlier, have damped the Federal Reserve’s extraordinary attempts to re-inflate the burst credit bubble. The result has been enormous pools of liquidity that cannot really go anywhere, and collapsing interest rates. Banks unable or unwilling to lend motivates the monetary authorities to look for other ways to pump more liquidity into the economy, such as printing new money (or the electronic equivalent of it) to buy Treasury instruments and mortgage debt. Credit Binge II also features massive deficit spending by the US government in an attempt to prop up consumer demand, financed by a lot more borrowing by the US Treasury.
People may contend that things are not so dire for banks, that they have been selling assets and deleveraging, and raised new capital. It is all an illusion. In a crisis people tend to sell their better assets, which were not the cause of the problem in the first place, and hold on to their worst assets because selling them would reveal losses too painful to bear. Because of this, the concentration of bad assets hidden on the balance sheets may actually be going up as a percentage of total assets.
People bullish on banks should realize that the banks are not playing their game of pretending to have capital while their balance sheet heals during the booming 80s and 90s, they are doing it after the credit bubble has burst and condemned all of us to seven lean years. The prospects of banks bootstrapping themselves out of the swamp this time is pretty poor. There will be more trouble for the big banks in the future.
Some have labeled the present government policy of near zero short term rates ZIRP (zero interest rate policy). It is meant to force investors and lenders made risk-averse by the crisis, and the government’s response to it, to stop hoarding cash and to seek a better return in risky assets.
I regard ZIRP as an economic hallucinogen even more powerful than what was on the streets back in the 2000s and it may be setting us up for even more disappointing results. Credit managers and treasurers should be very careful about ZIRP’s ability to distort reality.
Here are some recent examples:
Mexico, one of the sovereign defaulters back in the 80s and the protagonist of the Peso Crisis in 1994, has recently issued a bond due in 100 years at 5.75% coupon fixed for the entire century. This bond was placed with a handful of long-term investors seeking something higher than the sub-4% yield on the 30 year US Treasury bond.
These guys are not buying this bond to surf its huge duration, because there is no secondary market for it. They plan to hold to maturity. Imagine the risk of owning a bond for a whole century. To put this into perspective, from July 31st, 1960, around the time Chubby Checker was introducing the Twist, until July 31st, 2010, when Lady Gaga does whatever she does, the US dollar managed to lose 86.4% of its value. Now, the CPI is an admittedly imperfect index and the past 50 years have been unusually inflation-prone, but who is to say that we will not have another inflation burst in the next century? Clearly these investors are tripping on ZIRP.
Another example: Peru issued a 27 year bond at a fixed 6.9% coupon denominated in the local currency, the new sol. The bond now trades at about a 20% premium which gives it a yield to maturity of 5.4%. The new sol replaced the inti as Peru’s currency back in 1991 at the rate of one new sol for a million intis. The new currency was made necessary by the disastrous policies of Peru’s government back in the 1980s which resulted in hyperinflation. The new sol is viewed as the poster child of the good Latin American currency, which in some ZIRP-addled minds justifies the extension of a 27 year credit at the preposterously low yield of 5.4%.
It Is Now Harder Than Ever to Make Countries Pay
The era of high liquidity has also made it harder to make countries pay when they are reluctant to do so. High liquidity or easy money has interacted with other factors to give countries more leverage.
These factors include:
- the securitization of emerging market debt
- the advent of bond funds as holders of EM debt
- the unprecedented demand for bonds due to:
- retiring baby boomer demand for bonds and, more recently,
- fear of the stock market’s volatility
- the rise of highly skilled legal representation of defaulting countries
- the emergence of the recalcitrant debtors: Argentina & Russia,
and
the inclusion of collective action clauses in debt documentation.
Let’s look at each of these in turn.
First, securitization.
Perhaps the most important factor that has contributed to the erosion of the position of creditors has been the trend towards securitization of debt, the mere fact of countries borrowing by issuing bonds (securities), rather than borrowing from banks.
As I mentioned earlier, back in the 1970s the only people willing to lend to emerging market countries were the commercial banks which formed loan syndicates led by the large American institutions, the money-center banks as they were then called. When countries got into trouble these big players were able to present a united front in dealing with the distressed debtor. The borrowing countries needed the banks for trade credit lines and other types of financing so they had a lot of incentive to maintain good relations with the banks by repaying their loans on time This made the negotiations between the banks and the borrowing countries mostly collegial.
Now, with sovereign debt principally in the form of bonds as opposed to syndicated loans, the creditors are a widely dispersed group of institutions and individuals so it is much harder for creditors to find leverage or to act in concert to force repayment when things get dicey. Believe me, a half dozen big banks such as Citibank and J.P. Morgan have a lot more leverage than a thousand dentists in Belgium or Italy who are holding Russian bonds! So, my first point to you is that the mere shift from bank loans to the securitization of sovereign debt as the principal means by which countries borrow money has had a profound impact on the risks associated with being a creditor to a foreign country, especially those in the emerging markets.
The second factor that has changed this market is the rise of the Bond Funds.
The largest holders of sovereign debt are now the bond funds, not the banks. You might think that these funds, often managed by large financial firms would, like than banks, have a lot of leverage, but it’s not the case. Why? Because the way funds deal with troubled borrowers is very different from the way banks deal with them. If a borrower is showing signs of distress, banks take steps to “work-out” the troubled credit in their portfolio. They may use covenants to push the borrower in the direction of more sustainable operation or organize a restructuring of the debt with other creditors. The bond funds, however, take a much more detached approach to a troubled borrower: they simply sell their holdings of such bonds. They kick the can down the road, so to speak.
Why?
Because these funds are required to value their holdings at market prices on a daily basis. So, when the value of a particular bond heads south, it’s immediately reflected in the NAV of the fund. Unless the fund manager has good reason to believe the price will bounce back, it’s easy to just sell the asset. He or she doesn’t enter into workout discussions with the issuing country. Unlike the banks, the funds have no relationship to protect. They’re just buying and selling. Think of it this way: the banks were married to their borrowers, the fund managers are just dating.
The rise of the individual bond investor and the bond funds as holders of sovereign debt and the inability of these investors to put effective pressure on defaulting borrowers created a niche for funds specializing in buying the defaulted debt of countries. These funds, dubbed vulture funds by their detractors, do the essential work of holding irresponsible sovereign borrowers to account. These unsung heroes include Kenneth Dart and Elliott Management, along with a few smaller groups. My company, Turan Corporation, has participated in some of these transactions.
The vulture funds cut though all the rationalizations defaulting countries have for their situation by seeking creative ways under the law to receive payment for the debt they acquire. They provide the incentive for wavering debtors to service their debt or to restructure it responsibly with the consent of the creditors.
Another factor contributing to the risk for investors in sovereign debt is the emergence of highly skilled legal representation of defaulting countries.
Certain major law firms have taken up the defense of defaulting countries, such as Russia and Argentina, have made a significant difference in eroding the ability of creditors to secure judgments against defaulting countries and to enforce judgments.
Now let’s move to the so-called Recalcitrant Debtors: Russia & Argentina.
Russia inherited most of its foreign debt from the Soviet Union, although all of the local currency debt at the core of its 1998 default was incurred by the new Russia. Creditors of the Soviet Union made ingenious attempts to attach assets of the Russian government ranging from enriched uranium held at a facility in Paducah, Kentucky, to the tall ship Sedov, to the jet fighters that might have attended the Farnborough Air Show in England.
Along the way, these attempts resulted in legal precedents that significantly moved courts in the US away from holding central banks of countries responsible for their commercial actions.
Russia broke new ground in dodging creditors by creating a private entity where it could hide its reserves in off-shore accounts out of the reach of creditors. This highly unorthodox scheme was audited by PriceWaterhouseCoopers, and blessed by the IMF, creating another bad precedent for dubious behavior by sovereign debtors.
Russia, now an investment grade bond issuer, was warmly received in its return to the Eurobond market this year. The bond market, made irrational by walls of investor money seeking yield, has conveniently forgotten how poorly Russia treated its bank lenders, trade creditors, and bond holders. Russia used a brief drop in oil prices during 1998 to extract deep concessions from its bank creditors, that resulted in much Soviet-era debt being reduced by about 37%. Despite the fact that oil prices tripled the next year, Russia held its creditors to their concessions ignoring its vastly improved financial situation and restructured its debt in early 2000.
Trade creditors of the Soviet Union were forced into this same deal, but had to wait years for Russia to actually keep its part of the bargain. They were put at the mercy of the Russian bureaucracy supposedly to “reconcile” the amounts owed. The process of “reconciling” the trade debt took nearly a decade after the bank deal of 2000 to arrive at some type of conclusion, but there are still trade claims pending. War ravaged Iraq, by comparison, managed to reconcile all its trade claims in a matter of months. Yet, the bond market views Russia as a fine credit.
Argentina’s default in 2000/2001 broke a record for size, nearly 100 billion US dollars. Argentina also stands out as a bad debtor for having defaulted on debt to the World Bank, a concessional lender nobody in his right mind would default on because they lend at long maturities with low interest. After its $ 100 billion default, Argentina let creditors wait until 2005 and then presented them with a highly coercive deal worth somewhere around 25 cents on the dollar. It told creditors, participate or your debt will be worth nothing because our legislature has passed a law forbidding any deal with creditors who do not participate in this one. 76% of creditors accepted the exchange in 2005.
Some of the outraged holdouts from 2005 took legal action against Argentina in US federal court. The court issued numerous judgments against Argentina. However, the judgments awarded to Argentina’s long-suffering lenders have proven nearly impossible to enforce. The country has, using the advice of its sophisticated attorneys, hidden its assets in places not accessible to creditors. The tacit cooperation of international entities such as the Bank for International Settlements (the central bank for central banks) with Argentina has also made recoveries difficult.
In 2010, Argentina made another offer to exchange its defaulted debt under terms equivalent to the 2005 exchange. The latest exchange was accepted by 66% of the holdouts. Many of the remaining holdouts continue to press their legal cases.
It should not surprise you to hear that Argentina, despite having terribly mistreated its creditors, hopes to return to international bond markets in the near future; it should surprise you even less that the bond market, desperately seeking yields, would welcome it back.
Finally, let’s spend just a moment on Collective Action Clauses.
These are provisions in bond indentures or loan agreements that allow a supermajority of creditors, say 75%, to force a restructuring on dissenting creditors. Such clauses make it impossible for holdout creditors to seek a separate deal with the borrower.
Collective action clauses make it much easier to reach a restructuring deal with the defaulting borrower. The borrower needs to offer a deal good enough to satisfy only a supermajority of holders to protect itself from the threat of litigation. The result, typically, are restructurings that are, on the whole, more favorable to borrowers. These clauses are thought to create a moral hazard by tempting weaker borrowers to default, safe in the knowledge that they will be able to cut a nice deal with the apathetic majority of creditors and not have to bother with the troublesome minority. So, if you invest in sovereign debt, beware the collective action clause!
Emerging Markets Have Progressed Greatly, But…
The excess liquidity and low interest rates in developed economies, together with their slow growth, have pushed companies and investors to increase their activities in emerging economies where growth has resumed post-crisis, or never stopped at all. Emerging economies and their stock markets are beginning to show signs of overheating from the attempt to recycle liquidity from developed markets. In this context, it is important to put into perspective what emerging countries have achieved and what they have failed to achieve.
In judging the progress of emerging economies I like to look at two extremes and one case that is just about in the middle of the pack.
The outliers are Chile and Venezuela.
Chile has continued to strengthen its internal institutions and markets. The results are evident in the valuation of its stock market which is over 40 percent above its pre-crisis peak. This is no doubt attributable in part to its highly successful defined contribution retirement system which provides depth to the country’s capital markets not seen in any other emerging economy of its size. Due to high participation in this retirement scheme, Chile has no huge pension liabilities hanging over its head.
Chile has always stood out in Latin America for the integrity of its legal and political system, but it is surprising to realize that Transparency International ranks Chile well ahead of Spain, just behind France, and only six places behind America, in its Corruption Perceptions Index. The country has done a lot of things right. Because of its resilient institutions and deep local markets, it has been able to respond effectively (despite early glitches) to natural disasters in February of this year that destroyed property valued between 7 and 19% of GDP. They also proved pretty good at extracting miners trapped 2000 feet underground.
Venezuela, on the other hand, has lost ground in the most recent decade as the Chavez regime has systematically attempted to undermine the rule of law and place all sectors of the economy under government control. The country has sunk from 25th percentile in the Corruption Perceptions Index to the 10th percentile. It used to share rankings with Moldova and actually outranked Georgia. In the 2009 report, Georgia had climbed to the 65th percentile and Moldova to the 50th. Venezuela now shares its rankings with the Congo and Kyrgyzstan.
Foreign and domestic investors have fled as the government confiscates businesses and puts then in the hands of cronies and apparatchiks. In this era of free foreign exchange markets, Venezuela has strict currency controls and a vibrant black market for US dollars. The country recently established a food rationing board. Investors have so little trust in the future of the country that Venezuela’s stock market is priced at 1.64 times earnings at the same time other emerging country markets are priced at lofty multiples. This contrasts with Chile’s multiple of 32 times earnings and Nigeria’s of 27 times earnings.
Brazil is my middle of the pack example. It has made great strides, but still confronts many obstacles. Having tamed inflation and reformed some of its laws regarding collateralized credits and real property, the country is well on its way to building a credit system to support the expansion of its consumer economy. Brazil has broadened its export markets and built the skills of its professional class to developed country levels; Brazil has even found significant oil reserves. However, the country continues to be afflicted by structural rigidities that give it the one of the highest inflation adjusted interest rates in the world, substantially restraining the growth of the consumer economy. Its world-class professionals lack the support of well-trained technicians, nurses and other skilled workers needed. There has been reform around the edges, but the country’s legal system continues to be problematic.
Despite all the progress Brazil and Chile have made in diversifying their exports, their economies, like Venezuela’s, continues to be dependent on commodity prices which are driven by external demand, presently created mostly by China. I believe that the good performance of these economies (Venezuela aside) and the high valuations of their debt and equity have a great deal to do with high commodity prices and high liquidity in the portfolios of investors in the developed world. All three countries would suffer from a sharp drop in commodity prices or a rise in interest rates.
What to Do I Fear in Emerging Markets?
In three words: The China Bubble
Now, many of you are thinking that the surest way to end your career is to be seen as getting in the way of doing business in emerging countries, particularly China. I am here to urge you to be very cautious with your emerging market ventures. It’s a lot later in the party than most people realize.
As I mentioned earlier, the phenomenal creation of credit caused by Credit Binge I and its continuation under Credit Binge II have raised the price of investments in emerging markets and stocked the foreign exchange reserves of emerging countries with an unprecedented hoard of US dollars. America has no monopoly on foolish decision making under the influence of huge liquidity.
In 2009, China launched a stimulus program that disbursed about 11% of GDP in about 6 months, principally through lending. Lenders and credit managers will no doubt agree that such massive lending in such a short time involved a lot of very poor decisions that will come back to haunt the banks and Chinese authorities, if they are not already doing so. China has also used its pile of dollars to go on a foreign spending spree for natural resources around the world, frequently at premium prices.
This reminds me of Japan’s bubble at the end of the 1980s, when the land surrounding the Imperial Palace in Tokyo was said to be worth as much as all of California, and Japanese companies, propelled by sky-high share prices, were buying trophy properties like Rockefeller Center at premium prices. The bursting of the Nikkei Bubble is worth studying.
By the 1980s, the post-war Japanese economic miracle had matured to the point that Japanese companies were finding it hard to develop investment projects that would allow them to continue to grow. Their response was zaiteku, investing in securities and real estate to boost their returns. This type of speculation led to mutually reinforcing bubbles in Japan’s stock market and real estate market. Since the bursting of the bubble in late 1989, the Nikkei Index has never gotten above 69% of its previous high, and now trades at less than 25% of its bubble peak. That’s what a burst bubble looks like. The value of things go down a lot and never come up again.
When the China Bubble pops, as it inevitably will, the bubbles in the rest of emerging market countries will also pop because China will cease propping up the price of commodities on which most emerging economies still depend. There will be tears in emerging economies when China bursts. The price of commodities and companies will drop a lot and not recover.
Foreigners Rush In Where Locals Fear to Tread
Much of my youth was wasted in darkened rooms consuming the only occasionally edifying product of Hollywood. I remember movie scenes where foreigners on an expedition in a wild place wake up to discover that all their native helpers and porters have fled, the implication being that the locals know something the clueless foreigners don’t. The real fear of that happening to you in an economic sense is perhaps the best lesson to be learned from the silver screen.
Back in the late 1990s, Russia was one of those wild places where foreigners went to find the returns and the sense of adventure lacking in their home markets (for some the Tech Bubble was not exciting enough). I was one of those adventurers. My debt trading business led me to accumulate large positions in Russian obligations. With all the excitement about the huge profits to be made in Russia as it emerged from Soviet-era constraints, I neglected to keep an eye on what the locals were doing.
The year preceding Russia’s partial default in 1998 was marked by large scale capital flight from Russia. The capital fleeing was that of Russians who were in the know and could see that there were no more big gains to be made in their market. After the default and the subsequent depreciation of my portfolio, I felt a lot like those movie characters coming out of their tents to discover the locals had fled.
My friend George Friedman of Stratfor, the provider of geopolitical intelligence, believes that Chinese acquisitiveness towards foreign assets is just a manifestation of capital flight. He thinks that Chinese buyers of foreign assets have realized that there is a dearth of attractive investments in China and seek to shelter their capital through foreign acquisitions. I agree with this observation.
When will the China Bubble burst? I don’t know. The bubble in its stock market has certainly burst, its real estate bubble may be next, but the retrenchment in the commodity markets that would affect the other emerging economies could take several years.
But many will argue that China holds trillions of dollars in reserves and that all that liquidity will serve to cushion the effect of the bubbles bursting. My response is to think back to 2008 and how quickly all the huge liquidity of the 2000s simply disappeared as people sought to sell their risky assets for cash. The same will happen in China. We will discover that the claims on those gigantic reserves are even more gigantic still.
I urge you to make your credit decisions always with a thought to what might happen when the dam bursts in China and floods all the emerging markets with problems.
Some Practical Advice to Protect Your Credit Portfolio
Here I address the third and last objective of my talk, advice on how to keep your credit portfolio from suffering avoidable misfortunes.
(1) Attend FCIB conferences and become involved in the organization. The conferences and the contacts I made at the conferences were the best source of business intelligence I had. I hated to miss a conference because I knew I was missing out on important things.
(2) Read a lot about the area you manage. I recommend the Financial Times, which provides broad coverage of even small markets other business publications ignore. Subscribe to services like Armada Global Intelligence or Stratfor and keep up with what they report in your region.
(3) Go to the region regularly and talk to the local business people. It’s also a good idea to cultivate the local FedEx or DHL managers. They are likely to speak English and be aware of things in local markets because they will likely be locals. Attend local Rotary Club meetings even if you don’t speak the language. An English speaker there will seek you out to practice his or her broken English on you.
(4) Don’t be afraid to ask embarrassing questions. If they get answered they usually reveal something valuable. I remember putting some blunt questions to an Argentine financial official at an IMF meeting in Istanbul about creditors who did not participate in the 2005 exchange. His favorable response helped me make the profitable decision to take more Argentine risk.
(5) Watch for signs that local capital is fleeing. An obvious indicator is the presence of a black market for US dollars. Another one is locals going overseas to buy foreign assets at inflated prices.
(6) Read closely Nassim Taleb’s “Black Swan” and heed his objections to the financial models we use. His critique has been vilified, ignored, and, at times, grudgingly accepted, but never convincingly refuted. Please realize that we almost always know a lot less about markets that we think we do.
(7) Read “This Time Is Different” by Reinhardt and Rogoff. This excellent study of centuries of financial folly illustrates how economic decision makers always forget the lessons of history and repeat the same mistakes.
In closing, I would like to leave you with a quote from Chuck Prince, another CEO of Citigroup. In 2007 as Credit Binge I was reaching the end he said to the Financial Times:
“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Well, I suggest to you that if you are, like Chuck Prince, still dancing it is worth remembering that the party you are at is an illegal speakeasy, that the girl you are dancing with is a minor and that the police are already on their way!
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