Escape to El Dorado: Why are investors venturing again to the Third World where they got burnt in the 1980s? Peter Krijgsman examines the allure and the risk

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The Independent Online
Last Summer, Morgan Grenfell tried to launch a fund investing in Russian debt by raising money from investors in London and New York. The fund would probably have been a runaway success had it ever got off the drawing-board. For a very unusual reason, however, it was never launched.

The bank's team, led by Rick Haller, its emerging markets expert, set up a roadshow in July to attract investors with the prospect of 100 per cent returns on Russian government debt. For any banker to promise hardened professional fund managers a return that high, he has to be confident he has something remarkable to offer. The Russian market was just that.

When the deal was being presented in London, the debt was trading 'in the 20s' - that is, between 20 per cent and 29 per cent of its face value. But by the time the roadshow arrived in New York a few days later, the 100 per cent return had already been achieved, with the debt trading in the 40s. Haller's promise had been fulfilled faster than even he had anticipated - and too fast for his fund to get its money invested in time. The fund, as a consequence, had to be ditched, although Morgan Grenfell could at least console itself with a handsome profit on its own account.

The bank is, however, only one of a large herd of Western financial institutions stampeding through the markets of the Third World. For the single most striking trend in world finance since the collapse of the Soviet Union is an intense interest among investors and bankers in emerging markets. It is the financial fashion of the moment. For those willing to take the risk, the returns can be astonishingly high - higher, indeed, than almost any other investment available anywhere. This has created an uncomfortable paradox: from Bombay to Buenos Aires, the poorer countries have become the best places for the rich investors to get richer.

Just over 11 years have passed since the heavily indebted countries of Latin America said they could not pay their outstanding bank debts, an event which pushed some of the world's biggest banks to the brink of bankruptcy. Today, those banks, and many more besides, are courting not only the Latin Americans, but also the Chinese, the Thais, the Koreans, the Indians, some East European countries and even African states.

The natural question is whether the emerging markets boom is simply a precursor to another crash. The Latin American debt disaster struck so quickly that even the shrewdest investment banks on Wall Street were caught on the hop. During the summer of that year Merrill Lynch led a big Eurobond issue for the United Mexican States. It was launched in July and even grew, to dollars 500m, due to good demand for the paper. When the Mexicans announced on 12 August that they were suspending repayments on foreign debt, it was red faces all round at Merrill.

Yet a banker who was there at the time said that an internal inquiry into the fiasco showed the company's officials had done all they could and asked all the right questions to establish the risks of the deal. The Mexicans had simply caught them, and everyone else, by surprise. No one could conceive of a country taking such a seemingly suicidal step on the world stage.

Yet events have since shown that the crisis was temporary. Mexico, and the other Latin American states that followed it into default, effectively cut themselves off from the international capital markets' supply line. When Mexican entities finally returned to the public markets in 1989, they paid more for less money.

An illustration: in 1982 Mexico was paying about 1.5 per cent more than the US government - the benchmark of international capital markets - for its money. In 1989, the state-controlled Banco Nacional de Comercio Exterior (Bancomext) broke the ice with a deal that paid about 5 per cent over US government bonds for its money.

Judging from the enthusiasm of the emerging markets participants today, however, the debt crisis might never have happened. Securities issued by Latin American companies and governments have become hot stocks, in both equity and bond markets. New issues of equity are often heavily over-subscribed. International bond issues, in market parlance, fly out the window.

Although they are the latest fad among international bankers, there is a compelling logic behind the attraction of emerging market funds. Part of it is due to the lack of income in other bond and equity markets. US government bonds, for instance, are now yielding 3- 6 per cent, and it has become difficult to attract investors with such meagre returns. The low dividend payments and near-record price levels on the London FT-SE index are a common feature of mature equity markets around the world. Guy de Selliers, one of the leading investment bankers at the European Bank for Reconstruction and Development, says the risks of emerging markets have to be put into perspective. 'You have to be pretty gutsy to buy into any market today.' Necessity, in the form of investors' yield requirements, has become the mother of invention.

The same point is highlighted by Rick Haller at Morgan Grenfell. He says emerging markets are 'counter-cyclical, a residual choice'. They come into their own when other, more traditional markets are uncomfortably high. Haller's success to date has not been in Eurobonds or equities, but in the trading of emerging markets' government debt, most of it on a proprietary basis - ie, for the bank's own account. When Morgan Grenfell hired Haller a few years ago, he was given access to the parent Deutsche Bank's enormous book of dud sovereign loans. Last year his team traded dollars 70bn of them. The bank does not disclose its revenues from the operation, but it is credited as a key factor in Morgan Grenfell's return to health.

In the equity markets, the rising stock market indices tell their own story. While the S & P 500 in New York has risen by around 7.02 per cent so far this year, Brazil's Sao Paulo index has gone up by 104.09 per cent in dollar terms. Mexico, Chile and Colombia are all up between 27 and 40 per cent. Bankers handling last month's dollars 133m share issue for the Argentine power generator Central Puerto, claim the deal was 20 times over-subscribed.

The excitement is not limited to Latin America. Several of the so-called 'tiger' markets of Asia - Thailand, Indonesia, Malaysia, Singapore and Hong Kong - are up by between 50 per cent and 90 per cent this year. The peace dividend in the Middle East is another attraction. Miles Morland of Blakeney Management, an investment adviser on 'pre-emerging markets', says South African equities will go up like a rocket in the next six months. Barring what he sees as the '20 per cent chance of a cataclysm', Morland says South African equities are 'money sitting on the table, waiting to be picked up'.

Even the post-Communist stupor of East European equity markets is lifting. The Polish stock market, for example, has risen by 627 per cent since the beginning of 1993. Guy de Selliers of the EBRD says that he is getting calls from US investors asking to buy his employer's stakes in companies such as the Polish bank WBK, and the Czech chocolate manufacturer Cokoladovny. The bank has pounds 30m invested in shares in the two companies and is showing a return, after only a few months, of well over 100 per cent: getting on for enough to pay for the controversial marble-clad London HQ.

Returns like these create frenzies among international investors, anxious to catch the wave before it breaks. In emerging markets, the waves are still coming fast and furious. If Mexico loses its appeal, well, there's always Morocco or Russia. The current boom could still run for months. Big, well-known investor names are not buying into emerging markets to the exclusion of others, but they are allocating large amounts to augment their yields from more traditional areas.

Some investors, notably the big corporate and state pension funds, have yet to buy emerging market bonds at all. Many are constrained from buying 'non-investment grade' debt securities as determined by the big rating agencies, Moody's and Standard & Poor. None of the leading Latin American Eurobond-issuing countries have achieved that status yet, although Mexico is widely expected to cross the barrier in the first six months of next year.

Mexico has been on a roll for more than three years, and it has taken the rest of Latin America with it. Those countries that have signed their Brady debt recovery plans (devised by the then US Treasury Secretary, James Brady), such as Argentina, are especially blessed. Those that haven't - notably Brazil, which first needs an agreement with the International Monetary Fund - carry on issuing debt anyway. By the year-end, around dollars 20bn of securities issued by Latin American countries and institutions will have hit the international debt markets this year alone.

It is impossible to get an accurate assessment of how much money bankers and investors make from these deals. Roughly speaking, banks earn a net profit of 0.5- 1 per cent on new emerging market debt issues. So on Latin America's public Eurobond new issues alone, Wall Street's big investment banks will have picked up fees of around dollars 200m this year.

That is only the tip of the iceberg. The private placement market could well double that figure, while commissions earned on trading in emerging market bonds - turnover pushing dollars 3bn a day in October, according to the international clearing-houses - and profits taken on proprietary positions would add a lot more.

In the equity sector, banks would pick up more in fees on each deal. On the dollars 6bn of new international equity offerings from the Pacific Rim countries, and India and Latin America, so far this year banks will have earned net profits of around dollars 180m. Equity market trading figures are hard to estimate, but Baring Securities, in its recent Strategy 94 emerging markets review, says a net dollars 38bn will have been added to the developed world's emerging market equity portfolios this year, twice as much as in 1992. Next year, the firm forecasts, a further dollars 45bn will be ploughed into the region.

Some of the more sensational stories make it hard not to condemn the greed of individual investors. For example, the highly secretive Dart family, American controllers of the Dart Container styrofoam cup empire, is reportedly holding up negotiations for Brazil's Brady Plan. The Darts have owned dollars 1.4bn, or about 4 per cent, of Brazil's foreign debt, bought in the secondary markets at huge discounts last year. Their profit on the Brady Plan which they are resisting is estimated at dollars 270m. They are holding out for an alternative plan that would earn them dollars 360m.

A more fundamental concern is whether the debt crisis of 1982 will repeat itself. The answer is that it probably will not - or at least not on as large a scale. One important difference between the capital flows to Latin America in the 1970s and the current borrowing and investment boom is that in the earlier period the money went to governments - usually dictatorships, invariably corrupt and hopelessly inefficient at spending the bank loans.

This time most of the investment is going to the private sector. This, according to market participants such as Haller of Morgan Grenfell, makes a re-run of the debt crisis less likely. 'During the last debt crisis you had little foreign investment in shares. The banks were messed around by governments, not the private sector.' If a private company got into trouble it might miss a dividend or bond coupon payment without pushing the financial system into free fall.

The point is echoed by Dan Smaller, head of emerging market equities at Lehman Brothers in London. 'There will be companies that go bankrupt, and this will cause market hiccups,' he notes. But he adds that the investor base is now wide enough to accommodate rough rides.

Instead of the commercial banks' one-way herd instinct of the Seventies and early Eighties, Smaller says, there are now enough 'bottom-up' investors - buyers, such as global 'sectoral' funds looking for value in specific industries worldwide, who will step in when the market tumbles low enough - to counteract the 'top-down' institutions that sell when trouble brews.

When the Mexican stock market tumbled last year, Smaller says, holdings by Lehman Brothers' retail clients in American Depositary Receipts, representing shares in Mexican companies, actually went up.

Local pension funds are also bolstering liquidity in the markets. Pension reform in Chile, which has created private pension funds in place of the old, corrupt state-run version, is being copied throughout Latin America. As these funds become established, they will invest in the local stock and bond markets, adding depth to the market. In Argentina, local bankers say the new pension funds will be pushing up to dollars 350m per month into the local markets, mainly in government bonds, but also in local equities, private sector bonds and, indeed, international securities.

In other words, the supporters say, the 'emerging' markets are becoming like any other.

But investors would be foolish not to realise that there are huge differences between these markets and the traditional ones. Investment risks, as perceived through linguistic and cultural barriers, are not as well understood as those of a straightforward domestic investment. And the political risks, in countries where enormous pockets of private wealth are thrown into stark contrast by millions of slum-dwellers, are ever-present.

In Brazil, for example, inflation is still at surreal levels, sending the local currency plunging in value against the dollar. The 104 per cent dollar-adjusted 1993 increase in the Sao Paulo stock exchange index translates to a 3,681 per cent increase in cruzeiro terms. Brazilian finance directors pay no attention to meaningless annual profit and loss statements, but receive daily sheets translating revenues through a host of official and internal inflation indices. They, no doubt, understand them. It is unlikely that anyone does at the Pru.

According to researchers at Salomon Brothers, the different financial management practices in Latin America require different evaluation techniques. The US investment bank has developed a scoring system for Latin American companies using alternative ratios, such as cash earnings to interest expense and total debt to capital. One number that keeps cropping up in the analysis is Ebitda - an acronym for earnings before interest, tax, depreciation and amortisation. If that looks familiar, it is because it was also used heavily by promoters of management buyouts in the US and the UK in the Eighties financial boom. Suspension of disbelief does not always result in mega-returns.

It is also important to distinguish between types of private-sector borrower. Some Latin American bank issuers, for example, borrow money at (cheaper) Eurobond market rates and then lend the proceeds, at much higher local dollar interest rates, to domestic residents for short-term mortgages. The spreads are enormous, but the risks, to borrowers and investors alike, are evident. Easy credit at sky-high prices can cause trouble.

And the old threats of macro-economic turmoil have not vanished. Some Brazilian Eurobond issues include 'dollar constraint language' in their new issue prospectuses. In plain English, these clauses allow the borrower to repay the foreign currency investor in cruzeiros, should the Brazilian government introduce foreign exchange restrictions, as in the debt crisis of 1982.

The implication of this is that the borrowers will not technically default on their bonds, even though their payments on them could be virtually worthless. Some bankers think that a proliferation of dollar constraint bonds could reduce the disincentive of the Brazilian authorities to introduce foreign exchange controls.

There is also some concern as to whether Eurobond investors are fully aware of the dollar constraint clauses, especially in the secondary market, where the original prospectuses of the bonds are not generally available.

The International Primary Market Association, a London-based trade organisation representing Euro-equity and Eurobond underwriters, has discussed the issue. Some members are calling for a two-tier market, separating Latin American bonds from more established issuers. While the Brazilian authorities complain that the IPMA's noises have raised the cost of Brazil's international borrowing, the IPMA's attempts to open up talks have so far failed.

'We have had questions from Brazil, but have seen a distinct reluctance to enter into a dialogue,' said the IPMA's secretary-general, Dirk Hazell.

But Brazil is the extreme case. Dan Smaller at Lehman Brothers says emerging markets have 'grown from a wannabe asset class to a full-fledged asset class in their own right'.

He cites two reasons. First, the end of the Cold War meant that governments which had a choice between IMF austerity packages and handouts from the Soviet Union lost the easier option. As their economies become more efficient, international investors will continue to invest in them. Secondly, the enormous growth in the number and size of private pension funds, both in the developed world and the emerging markets, has created a self-replenishing wave of money that is constantly looking for somewhere to go.

As long as interest rates stay low in Europe and the US and stock markets stay high, no one is claiming to see the end of this particularly profitable tunnel.

----------------------------------------------------------------- SOARING MARKETS GROWTH IN DOLLARS TERMS IN 1993 ----------------------------------------------------------------- Country % rise Brazil 104.09 Colombia 41.78 Mexico 37.53 Peru 68.66 Turkey 174.79 Poland 627.94 India 15.83 Pakistan 25.48 Hong Kong 82.53 Indonesia 87.03 Malaysia 69.15 Philippines 82.38 Thailand 66.77 Source: Lehman Brothers -----------------------------------------------------------------

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