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. Last Updated: 07/27/2016

Bond Markets Bracing as Brazil Nears Brink

Brazilian left-wing Workers' Party presidential candidate Luiz Inacio Lula da Silva seems to have won over the hearts of the country's electorate with his promise for more state spending.

But he has yet to win over international investors, who hold a significant chunk of Brazil's $340 billion in debt. They have been pulling money out of the country as he rises in the polls and may leave en masse should he become the next Brazilian president.

And that could be bad news for the Russian bond market, some analysts say.

Brazil: Default Ahead?

Lula has said that as president he would pay the country's debts, keep inflation under control and maintain a balanced budget. But major international funds heavy in high-yield Brazilian debt instruments have been skeptical that he would honor debt payments. The radical leader has, in the past, criticized Brazil's heavy debt burden, and his current platform calls for an increase in social spending, a policy that would lower Brazil's budget surplus and eat up funds for debt repayment.

As Lula, as he is called, rose in the polls this spring to command a 17-point lead over his opponents with first-round elections less than a month away, investors began pulling money out of Brazil's capital markets, setting off a crisis. The Brazilian real fell 20 percent while the price on the Brazilian C-bond, the country's benchmark hard-currency debt instrument, dropped 40 percent from April and yields rose to 24.68 percent on July 31, its highest level since early 1999.

Investor moves could make debt default almost a given should Lula win.

"It will be a self-fulfilling prophecy," Aton economist Peter Westin said. "Investors will start moving money out of Brazil if he looks set on the belief the country will eventually default. And that will bring about a default."

Sell-Off Warning

If Brazil does default on its loans, it would be the largest default ever and could send emerging debt markets into a tailspin.

Investors have already been burned twice in the last nine months, with defaults in Argentina and then Nigeria. A third would reduce investor appetite for risk, sparking a sell-off of emerging market debt, some analysts say.

The contagion could hit Russian bonds.

"Where Russian Eurobonds go depends highly on Brazil," Troika Dialog fixed income analyst Alexander Kudrin said. "There is a very high correlation between Russian and Brazilian bonds, and Brazilian bonds and Brazilian default would have a strong negative effect on Russian bonds."

Brazilian and Russian bonds are among the most liquid debt instruments in emerging markets and make up about 20 percent of model emerging market debt portfolios. The Russia '30, the benchmark Eurobond that matures in 2030, and the Brazilian C-bond turned in strong, closely correlated performances from October 2001 to April 2002, gaining 45 percent and 22 percent, respectively.

Since investor fears about Brazil began in mid-April, the price of the C-bond has dropped 25 percent. The price of the Russia '30, however, has remained steady, oscillating between 66 and 72 cents on the dollar over the same period. But the C-bond's 6 percent loss on June 21 and 7 percent fall on July 29 took the Russia '30 down 5 percent as investors sold Russian bonds to cover their positions in Brazil.

In case of a Brazilian default, Kudrin said the fall in Russian bonds would likely be similar to the fall of Brazilian bonds following the Russian default in August 1998 -- about 28 percent. Brazilian bonds recovered their losses by November 1998; Kudrin expects Russian bonds would recover in three to five months.

Russia Could Benefit

Some analysts say Russian bonds have begun to separate into a class of their own on the back of the country's strong economic performance of the last few years. As a result, contagion from a Brazilian collapse would be minimal.

"Correlations come and go and can disappear in a minute," Moscow-based fixed income analyst Letitia Rydjeski said. "Though Russia's budget performance isn't as strong as last year, it is still quite good, and there will still be good support for Russian bonds even if Brazil collapses." She said yields on the Russia '30 would not rise beyond 11.5 percent.

Russia is expected to post a 2002 current account surplus of 7 percent of gross domestic product and a budget surplus of 0.7 percent of GDP, giving it some of the best fundamentals among its emerging market peers. Standard & Poor's raised Russia's long-term credit rating to BB- from B+ at the end of July, just as turmoil in Brazil was raging. Russian bonds look like a safe bet even under worst-case global economic scenarios.

The quick rebound in Russian bonds following the crises last year in emerging markets Turkey and Argentina show that emerging market debt is becoming more country-focused, analysts say.

That may mean Russian bonds can capitalize on Brazilian misery.

"Even if the worst happens in Brazil, the effects will probably be more like Argentina, which was perceived as a purely country-related problem and resulted in more funds to Russia," NIKoil fixed-income analyst Boris Ginsberg said.

Likewise, the investor's best-case scenario, a victory for pro-government candidate Jose Serra, could put downward pressure on Russian bonds.

Chances of a Brazilian default would be slim with Serra in office, analysts say. Brazilian bonds, with their 22 percent to 23 percent yields, would thus be the best play in emerging market debt.

"If there is no crisis, some investors will move out of Russian bonds into Brazilian," Bank of Moscow trader Alexander Nikolayev said. He doesn't foresee Russian bonds climbing higher for the remainder of the year.

Yekaterina Lovova, a fixed income analyst at Alfa Bank, said a Serra victory could boost both countries' debt if it encourages investors to commit fresh funds to the market. With most emerging market debt portfolios overweight in Russian bonds, a high percentage of new funds would flow into Russia. She said Russian bonds could rise to 75 cents on the dollar under such a scenario.

New funds have been slow to enter emerging market debt lately. JP Morgan's latest emerging market client survey showed that investors are keeping 5.2 percent of their available funds in cash balances, surpassing the historical average of 4.3 percent. And that cash won't move if U.S. markets continue to falter.

"In case of a substantial slowdown in the U.S., we will see global risk aversion," Rydjeski said. "Investors will not be open to lending to emerging markets."

Analysts say Russian bonds won't move much higher until good news other than trade and budget surpluses and high oil prices comes out of Russia.

"The market mover now is reform," Westin said. "Investors want to see institutional reform, and their litmus test will be the utilities and gas industry."

With Russian elections in 2003 and 2004, analysts don't expect the government to move on such issues.