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IFR: Emerging Markets’ Egyptian Resilience

The market damage has been limited because foreign bond investors have only small exposures to Egypt, Tunisia, Jordan, Lebanon and the like.

February 4, 2011 2:44 by

Egypt’s political turmoil has provided a timely reminder of why EM bonds trade at a premium over the developed world.

Interestingly, however, contagion has been minimal in comparison with previous EM crises, and though things could take a turn for the worse if the Gulf becomes embroiled in democracy protests, a large-scale EM sell-off is not a realistic possibility.

Without doubt, EM has proved to be the relative winner of the credit crunch, emerging from the crisis as a huge global power house with vastly superior debt and growth outlooks than G7 and peripheral eurozone nations in particular.

This realisation helped pull the benchmark EMBI+ <11EMJ> spread down from a post-crisis peak of 862bp in October 2008 to around 250bp as the initial knee-jerk risk aversion retreat gave way to bargain hunting and vast increases in capital inflows based on the asset class’ excellent fundamental and technical positions.

However, recent events in Egypt – as well as the Ivory Coast, Nigeria and Belarus – have shown why the asset class must still pay a premium for the political risk that is implicit within non-democratic countries.

As far as Egypt is concerned, most fund managers are taking a fairly relaxed view, including those at Amundi, which has almost EUR700bn under management. “It is difficult to see default under any circumstances,” according to Sergei Strigo, the fund’s head of EM debt.

He pointed out that with more than US$35bn in reserves (as of November 2010), Egypt can easily meet its international bond liabilities as well as its local debt obligations, while its strong ties with the US are another supportive factor.

A deepening stand off between Murabak’s supporters and opponents in Cairo has dampened hopes for a peaceful transfer of power and stalled the recovery in Egyptian bonds that had been seen in recent days.

Egypt five-year CDS has climbed back up to 400bp having been seen as low as 350bp mid-market yesterday although it remains inside its recent peak at 475bp.

The 5.75% 2020s and 6.875% 2040s have slipped to 94.5-96 and 92.5-94.5, still above Monday’s 89-93 and 82-92 quotes although well below their pre-crisis levels of 100-101 in each case.

So far, the market damage has been limited because foreign bond investors have only small exposures to Egypt, Tunisia, Jordan, Lebanon and the like.

Nigel Rendell, senior emerging markets strategist at RBC Capital Markets, pointed out that “very few people hold investments in Egypt and, while there are some specialists in North Africa, this region is generally off the radar to the extent that Egypt can be described as an evolving rather than a mainstream EM country.”

Some contagion has spread beyond Egypt’s near neighbours with sub Saharan sovereigns, the Ghana and Gabon 2017s while the new Nigeria the new Nigeria eurobond due 2021 fell to 98.25-99.25, having traded as high as 100.5 after pricing at 98.223 on Jan 21.

Belarus has also struggled, underperforming the rest of CIS, as funds place more emphasis on political weakness in light of events in Cairo. But once again, none of the above are mainstream markets in which overseas funds are heavily invested.

A larger problem would develop if the democracy movement spread to the equally autocratic Gulf region which has been on a borrowing spree in recent years.

Thus far, there has limited impact on the secondary market, with sales restricted to credits which had exposure to Egypt such as Emaar Properties, although continued unrest in the MENA region could have an effect on the pipeline of deals building in the Gulf.

Rendell does see some potential problems in the UAE if democracy conflicts move there, especially with the Dubai restructuring still fresh in the mind.

“However, the relationship between the Middle East and the rest of EM is pretty tenuous. Of far bigger threat to the asset class would be if, say, a large Chinese bank became insolvent,” he argued.

One secondary consequence of the Cairo protests has been a greater appreciation of Western Europe’s political stability, which was perhaps undervalued when the market was focusing squarely on the eurozone’s refinancing problems.

Already boosted by hopes for an eventual easing of their debt burdens, SovX Western Europe has additionally benefited from their mature political systems to trade 40bp inside SovX CEEMEA, having started the year just wide of Europe’s benchmark Emerging Markets CDS index.

Overall, however, EM has proved remarkably stable in the face of Egypt’s woes, in stark contrast to the broad, overwhelming sell-offs provoked by the Mexican, Asian, Russian, Brazilian and Argentine crises.

After Russia defaulted on its domestic bonds in 1998, the EMBI+ soared to 1,700bp and took one-and-a-half years to fall back below 1,000bp, before hitting four digits again following the Brazil crisis of 2001 and Argentina’s default a year later.

Once the protests began in Cairo, the EMBI+ spread rose at most 40bp, from 238bp to January 28’s 278bp peak, before narrowing back to 250bp on Friday.

The credit crunch, by comparison, caused the benchmark differential to surge more than 500bp to 862bp, a situation Rendell does not expect to be repeated.

“Such was the severity of the credit crunch that investors piled back into their home markets and the dollar as all non-mainstream asset classes got hit. This produced a buying opportunity given EM’s performance since then and its potential going forward.

“Over a five to 10-year horizon, if you believe that China, India, Asia and Brazil et cetera will be the growth power houses then you must be invested in them in good times and in bad,” he said.

Evidence of EM’s increasing maturity is confirmed by the lack of safe-haven switching out of the asset class over the last couple of weeks. Instead, nervous investors have reallocated funds within EM, to Russia, Turkey and even Ukraine, rather than embark on flights to quality outside.

Looking forward, Amundi’s Strigo sees potential for further EM outperformance given that the EMBI+ spread is still trading around 100bp wide of its May 2007 low of 149bp. Similarly, Triple B EM corporates trade about 100bp-150bp wide of Triple B US peers, having been below 50bp for periods in 2006 and 2007.

Overall, Strigo is very positive for emerging markets whose GDP will represent half the world’s total by 2017, according to JP Morgan (and by 2020 according to Goldman Sachs), while EM debt represents only 2% of global pension funds allocation, despite accounting for 16% of global fixed income assets.

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