US dollar, bonds to benefit from debt downgrade

During the months of September-October 2008, governments throughout the world took a series of unprecedented steps to buttress tottering banks. In the USA, the Federal Reserve and the Treasury Department have flooded the financial system with liquidity; granted commercial banking licenses to the few investment banks left standing; lent funds against financial instruments turned toxic; and purchased non-voting equity and senior debt in a host of firms and banks. Several European countries have guaranteed all bank deposits and short-term interbank loans.

These steps served to halt the panic at least temporarily and have thus prevented runs on banks and the seizing up of the credit markets. Still, these were mere palliatives. They did not tackle the roots of the crisis, though they averted it.

Instead of eliminating risky, ill-considered investments and bad loans by allowing defaults and bankruptcies, governments have shifted debts and risks from financial institutions to taxpayers and sovereigns. The question was thus no longer: will this or that bank survive, but: will this or that country remain solvent. Iceland, for instance, essentially went belly up. Other countries, including the USA, are liable to pay for this largesse with a bout of pernicious inflation.

And even as the United States begins its long recovery, Europe and Asia are left to bear the brunt of American profligacy, avarice, regulatory dysfunction, and shortsightedness. According to a research note published by Credit Suisse, the Baltics, Bulgaria, Ukraine, Romania and Hungary "face many of the same macro-economic strains as Iceland, with deep balance of payments deficits and a high ratio of private sector credit to GDP". To these one can add South Africa.

Shifting risk from the private sector to the public one and from one locale (the USA) to others (Europe, Asia) are not long-term solutions. They only postpone the inevitable. The imbalances in the international financial system are such that unwinding them requires a prolonged and painful global recession. In economics, there is no free lunch.

Trading in Sovereign Promises

Martin Schubert and his New-York (now Miami) based investment boutique, European Inter-American Finance, in joint venture with Merrill Lynch and Aetna, pioneered the private trading of sovereign obligations of emerging market economies, including those in default. In conjunction with private merchant banks, such as Singer Friedlander in the United Kingdom, he conjured up liquidity where there was none and captured the imagination of businesses on both sides of the Atlantic.

Today, his vision is vindicated by the proliferation of ventures similar to his and by the institutionalization of the emerging economies sovereign debt market. Even obligations of countries such as Serbia and Iraq are traded, though sporadically. Recently, according to Dow Jones, Iraqi debt doubled itself and is now changing hands at about 15 to 20 cents to the dollar.

The demand is so overwhelming that Geneva-based brokerage firm Trigone Capital Finance created a special fund to provide interested investors with exposure to Iraqi paper. Nor is the enthusiasm confined to this former member of the axis of evil. Yugoslav debt is firm at 50 cents, despite recent political upheavals, including the assassination of the reformist and pro-Western prime minister.

Emerging market sovereign debts are irresistible. Some of them now yield 1000 basis points above comparable US Treasuries. The mean spread, according to JP Morgan's Emerging Markets Bond Index Plus is c. 600 points. Corporate securities are even further in the stratosphere.

But with frenzied buying all around, returns have been declining precipitously in the last few weeks. Investors in emerging market bonds saw average profits of 10 percent this year - masking a surge of 30 percent in Brazilian and Ecuadorian paper, for instance. JP Morgan Chase's EMBI Global index is up 19 percent since September 2002.

Nor is this a new trend. The EMBI Global Index has witnessed in each of the last four years an average gain of 14 percent. According to Bloomberg, the assets of emerging market debt funds surged by one tenth since the beginning of the year, or $948 million - compared to $648 received during throughout last year.