- A mere 15 years have elapsed since ‘Argentina’ and the next emerging market debt default has arrived: Venezuela
- Venezuela’s benchmark weight may seem small due to bonds already being priced at distressed levels; the scale of the risk is similar to Argentina in 2001.
- Assessing the timing of default requires two inputs: oil prices and the chance of political transition.
- We recommend investors take early note of their (managers’) exposure and positioning and assess their ability to weather this default.
Investors are not known for their long memories.
Merely 15 years have elapsed since Argentina’s default and the next emerging market debt default has arrived. The scale of the risk is similar to Argentina’s default. The face value market capitalization of the country’s benchmark bonds stands at nearly USD 17.93 billion versus USD 14.75 billion for Argentina in 2001. Taking the full view of liabilities, we believe Venezuela poses an even larger problem.
Total external debt, including state-owned companies, stands at nearly USD 120 billion, nearly 50% more than Argentina’s 2001 position (see chart below). The country’s lack of operating standards has left the market with at least 26 individual issues, in several different legal frameworks, linked to multiple government entities (including notably Petróleos de Venezuela) and with litigious cross-default clauses and substantial collateral attachment potential. The fact that China is now Venezuela’s single largest creditor, but does not participate in or adhere to Paris Club procedures, further complicates the story.
Exhibit 1: Venezuela versus Argentina total external debt
Source: BNP Paribas Investment Partners, Haver, as of 30 June 2016
How will the next emerging market debt default happen?
Ninety-five percent of Venezuela’s exports are oil-based. Extricating yourself from a discussion of oil prices (which have a multiplier effect on the country’s finances in both directions), Venezuela is now quite simply out of money and faces imminent dollar access shortages. We know the government is already running domestic arrears, prioritizing foreign debt service over payments to government employees and suppliers. We also know the situation has become a humanitarian crisis with accumulated product shortages now affecting the mass populace. We are watching the Venezuelan street for potential catalysts.
Taking a view on the timing of default requires two key inputs: firstly, oil prices, and secondly, the likelihood of political transition and whether that takes the form of economic revolution or opens up new sources of funding. Three possible scenarios result:
a) Oil rallies sharply, causing the likelihood of default and, arguably, political transition, to both recede
In this scenario, Venezuela can afford to kick the can down the road through a combination of heterodox policies and potential bilateral debt roll-overs. Bonds should do well in the near term; however, investors will ultimately focus on long-term structural issues. Oil prices are no longer enough to keep the Venezuelan economy on a sustainable track.
b) Oil remains depressed and the governing United Socialist Party of Venezuela (PSUV) remains in control
A default doesn’t have to happen this year, especially if Venezuela benefits from a mix of compressing imports, additional bilateral relief from China and regional support, further sales of gold reserves, prioritisation of debt service over other expenditures as well as a ‘voluntary’ debt exchange with investor participation. With such luck, it’s conceivable that Venezuela makes good on its payments this year. 2017 is another story. The country will have run down reserves perilously, with limited room for further import compression, and likely will not get enough investors to agree to the debt extension. Should Venezuela default, investors will assess expected recovery rates.
c) Political transition
This involves the possibility that Venezuela may not default even if oil remains weak, depending on what the political transition means for economic policy. A transition to more orthodox economic policies and an investment-friendly environment (coupled with improved relations with institutions that can provide emergency loans) could dramatically alter the market perception. In contrast, if a new government took a hard-line stance against bondholders and/or claimed that the debt is not legitimate, the path to default could actually shorten. The IMF’s policy on so-called bail-ins means debt forgiveness could be supported by the international community to the detriment of investors. Overall, it appears the market has been misreading a regime change scenario: a political transition combined with a painful restructuring is quite likely and we would not become bullish simply due to a new government.
Contagion and linkages
In the event of a default by non-payment (as opposed to pre-emptive debt restructuring), regional contagion is likely: economic linkages with Colombia and Brazil will prompt investors to second-guess their investments there first and ask questions later. Contagion could also touch the assorted Caribbean countries that have benefited from Venezuela’s Petrocaribe program.
With regard to sovereign default risk, the world has become too complacent. While we don’t believe that emerging assets are yet in bubble territory, we do see that the market has forgotten what an emerging market default means and what havoc contagion brings. We believe that a Venezuelan default will cause global correlations to rise.
We recommend investors take early note of their (managers’) exposure to Venezuela and their positioning (not all bonds are born equal) and assess their risk tolerance for weathering the default ahead. [divider] [/divider]
This article was written by L. Bryan Carter, Head of Emerging Markets Fixed Income, on August 29 2016 in New York
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