LONDON -- As the International Monetary Fund sends clear signals that it does not plan to prevent Ecuador from defaulting on its Brady bonds, emerging market debt managers are on tenterhooks.
The IMF's move to back Ecuador's restructuring is a major shift in policy and is intended to encourage "burden-sharing," in which international bond investors, not just the IMF, participate in refinancing bankrupt countries. The IMF is known to be applying its burden-sharing policy to a limited number of countries, and Ecuador is its first test.
And with the IMF and the U.S. Treasury known to be backing Ecuador's default and restructuring plan, money managers are concerned that other emerging market countries may follow suit with their sovereigns.
The Treasury and the IMF "are sending a message to international investors saying, 'Don't invest in these markets.' They are saying it's OK not to pay. This could also create a form of moral hazard by encouraging other countries to take the risk of default," said Jerome Booth, head of research for Ashmore Investment Management Ltd., London.
Late last month, Ecuador announced it would delay a $96 million coupon payment on its discount and past-due-interest Brady bonds before launching a restructuring of the country's dollar-denominated U.S. Treasury-backed debt. Ecuador has until Sept. 25 to make the coupon payment. In order to allay fears of a possible default, it recently announced it had sufficient funds to meet the bill.
Whether or not Ecuador meets this week's payment, there is no doubt it will have to restructure its debt portfolio. Details of the restructuring have not been published, but analysts expect to see bond holders offered a swap into other interest-bearing instruments. A forced restructuring such as a default on coupon payments will serve only to scare off investors and choke off the country's access to international capital, Mr. Booth said.
"You can't negotiate with bond holders. If you force a restructuring, you will reduce the flow of capital to developing countries. Emerging markets will be worse off," he said.
Ashmore has assets under management in emerging market debt of $550 million.
He is concerned other countries that are having difficulties meeting their external debt obligations may attempt similar restructurings with IMF backing, but other analysts say that this scenario is unlikely in all but the worst "basket cases," such as Ukraine, Pakistan and Moldova.
Default contagion from Ecuador to Venezuela, one of the market's current fears, is extremely unlikely, said Michael Cembalest, managing director of J.P. Morgan Investment Management Inc., New York.
Venezuela's debt to maturity profile is completely different from Ecuador's, and Venezuela continues to benefit from high prices for its oil exports.
"It is important to make the distinction that Ecuador is in this position due to structural deficiencies," said Patricia Goodstadt, emerging market debt portfolio manager for Baring Asset Management Ltd., London.
Major Latin American economies such as Mexico and Argentina have already bitten the bullet and begun implementing structural reform.
"Ecuador is really a small country and contagion will be limited," she added. But it is important for the IMF to publicly explain its burden-sharing policy by outlining which countries it will bail out in order to prevent further uncertainty.
"This is a small country and it won't have repercussions in terms of the rest of the financial system, which makes it a handy test case for the IMF to recommend a restructuring," said Jeff Gardner, research associate for Bridgewater Associates Inc., Westport, Conn.
Whether the IMF is right is a moot point, but Mr. Gardner feels it is unreasonable for investors to imagine they will always be bailed out by multilateral institutions. "The risk in these markets is well-defined. Anyone buying Ecuador today with spreads at 35 percentage points over U.S. Treasuries has to know it is close to default," he said.
"Ecuador does not matter. It has failed to reform its public sector financing and so it should default. This will have a salutary affect for other countries who realize they won't get bailed out," said J.P. Morgan's Mr. Cembalest.
He sees Ecuador as a "sideshow," as it has an allocation of 1% in J.P. Morgan's Emerging Markets Bond Index Global. Capital flows to other emerging markets will hardly be affected if Ecuador defaults on its Brady bonds, he added.