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Bracing For The Impact


Emerging-market bonds have been hot for the past year as U.S. Treasury offerings dropped to their lowest rates in decades. That has been great news for countries from Brazil to Russia. Investors searching for higher yields grabbed up emerging-market bonds, so the average spread between them and U.S. Treasuries has fallen from some 700 basis points a year ago to 451 on Apr. 21.

But with many signs pointing to a jump in U.S. rates this year, the developing world is bracing for a shock. The last time the U.S. sharply raised rates -- from 3% to 6% in 1994-95 -- the shift wreaked havoc in emerging economies. Worst hit was Mexico, where investors dumped billions of dollars' worth of risky, short-term, dollar-denominated debt, triggering a disastrous economic meltdown that spread pain throughout the developing world. A recent sell-off of Brazilian debt has some investors concerned that a similar scenario may unfold this year.

This time, though, the impact will probably be far less dramatic. For starters, few analysts believe U.S. rates will rise even a full percentage point this year, so don't expect a rush of money Stateside. And some developing countries have taken advantage of low rates to refinance and reduce their debt burdens. What's more, prices for the oil, soybeans, copper, iron ore, and steel these countries produce are at record highs, so nations such as Mexico and Russia have built up foreign reserve cushions. And the widespread adoption of floating exchange rates over the past decade makes weathering interest rate fluctuations easier. "The emerging markets are not as vulnerable as they were in the past," says Ignacio Sosa, a principal at Boston-based One World Investments, a $480 million hedge fund.

TAKING NO CHANCES. That's not to say there won't be any pain. Higher rates would crimp growth just as economies in many countries are starting to get off the ground. And a slowdown in China -- a real possibility -- could push commodity prices downward, hitting Latin America and Russia especially hard.

So issuers are racing to lock in low rates before the Fed takes action. Brazil, for instance, already has issued about half of the $5.5 billion it needs to raise on international markets this year. Corporate bonds are moving, too. In Russia, where the government is issuing little debt, oil producer Gazprom is planning a $1.2 billion offering, and investor interest is high. "Many issuers are trying to rush" to beat a rise in U.S. rates, says Pavel Mamai, a fixed-income analyst at Moscow investment bank Renaissance Capital. He says some 70% of the $5 billion in Russian corporate debt expected to be issued this year will come out in the first half. In South Korea, investors have oversubscribed corporate bonds launched in the first quarter by utility, transportation, and telecom companies. And in Brazil, pulp and paper giant Votorantim raised $300 million in April, bringing to about $3 billion the amount issued by Brazilian corporate borrowers this year.

Brazil continues to be the country investors worry about most. Its huge public debt, equal to 58% of gross domestic product, would be hard hit by a rise in U.S. rates. On Apr. 15, J.P. Morgan & Co. (JPM) issued a cautionary note for Brazilian obligations, citing the potential of higher U.S. rates and slow progress on economic reforms. Such sentiment could lead to postponement of some $1.5 billion in scheduled government bond issues, traders say. Brazil "is a yellow light; it has to be watched fairly closely," says Christian Stracke, emerging markets analyst for CreditSights. Sure, the ride may not be as rough for emerging markets as it proved to be a decade ago. But seatbelts might come in handy anyway. By Geri Smith in Mexico City, with Jason Bush in Moscow and Jonathan Wheatley in S?o Paulo


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