But if that reasoning is applied to DM bonds it would imply that DM bonds have become significantly safer since 2007 despite the fact that DM government debt levels have risen by more than 30% of GDP on average over that period. This seems a little bit illogical.
Still, it is not just markets that are sending this message. A new piece of research published by the Bank of International Settlements (BIS) reaches the same conclusion.
BIS looks at the question of ratings of EM and DM bonds and concludes that the significantly higher ratings given by ratings agencies to DM bonds – despite much higher debt levels – are entirely justified by fundamentals.
Unfortunately, BIS’s analysis suffers from several problems that render this conclusion invalid, in our view. Firstly, it is likely that the ratings bias is picked up by a more powerful explanatory variable they call ‘Default History’.
This variable is highly significant and very powerful in terms of its explanatory power. It measures actual defaults in the 1970s and 1980s. Very few developed markets defaulted outright in this period, while many EM countries did. This means that the variable acts as a de facto EM dummy variable, only more powerfully.
The other problem is that EM’s default history in the 1970s and 1980s is largely irrelevant to today’s default risk. EM was a very different place during the Cold War. It would have been far more appropriate to measure defaults from 2000 onwards after EM had fully adjusted to the structural break that was the end of the Cold War.
Finally, BIS’s ‘Default History’ variable only captures EM-type default events, not DM-type defaults. Developed economies generally do not default by non-payment. Instead, they use financial repression to force pension funds and other institutional investors to buy more bonds than they want and to accept losses through inflation.
They also pass losses onto foreign central banks by debasing their currencies. They are able to do this because of the limited choice of global reserve currencies. If the BIS analysis only measures defaults of the type you find in EM then no wonder EM looks more risky.
Venezuela’s opposition back in control
After sixteen years in retreat, Venezuela’s opposition took back control of the National Assembly (NA) following Sunday’s parliamentary election. At the time of writing, the final tally is not yet in, but it is already clear that the opposition will control the NA and could yet go on to securing a two-thirds majority if the final count pushes the opposition’s tally beyond 112 seats (out of the 167 available).
This would be sufficient to change Venezuela’s institution, such as the courts.
President Maduro has accepted the results and there has been no violence.
While the election outcome is positive the market will now focus on the most important question of all: What will happen to economic policy? Can the Executive and the Legislature – now on opposite sides – find a way to work together to reform the economy?
The opposition will act as a brake on the government through its majority in the legislature. The effectiveness of that brake depends not just on the opposition’s final tally in the NA, but also on the Maduro government’s ability to learn to be democratic. It must make this change, or risk going down.
Impeachment process underway in Brazil
Lower House speaker Eduardo Cunha formally commenced an impeachment process against President Dilma Rousseff. The outcome could be that Dilma is replaced as President by PMDB party President Michel Temer within the next six to nine months.
Under ordinary circumstances, the removal of a president would be bad news. But things are now so bad in Brazil that even the possibility of a resolution of some kind – this is the promise implied by impeachment – offers hope. Hence, this is good news.
The current Brazilian government is a lame duck administration mired in corruption and growing disunity. Brazil needs strong political and economic leadership. Almost all potential bad news is priced in. The fiscal deterioration is known, the bad growth picture is known, the judiciary crusade against corrupt officials is understood, downgrades are anticipated and USDBRL seems to really struggle to defend.
The main remaining risk not fully priced is the possibility of a bank run triggered by the troubles that have engulfed BTG Pactual, an investment bank. BTG Pactual faces the risk of going under (unless it either merges with a larger deposit funded institution or finds a strategic investor and increases its disclosure of assets), but there is very little systemic risk.
The main consequence could be further weakness in smaller banks, which depends on interbank and large institutional investors’ deposits, but even if a few of these banks go under the system is likely to remain solid.
The impeachment process offers a potential trajectory for asset prices similar to that of Argentina, where investors started to buy a long time in advance in anticipation of regime change. Six to nine months is a very suitable period over which to build a decent position in Brazil.
It is worth remembering that Brazil’s problems are entirely self-inflicted and ultimately cyclical in nature. Brazil will get through this very bad patch without a balance of payments crisis, without a sovereign default, they will not even need to bring in the IMF, in our view, due to Brazil’s strong deeper fundamentals. The impeachment process, if it succeeds, will take place within known and tested constitutional framework.