WORLD BONDS-Quick Iraq war may pose risks for emerging bonds

www.forbes.com Reuters, 03.19.03, 10:19 AM ET By Alexander Manda

LONDON, March 19 (Reuters) - Emerging market debt, which has returned a hefty seven percent to investors this year, may face selling pressure if war in Iraq is concluded quickly, as expected, due to falls in the prices of oil and safe-haven debt.

Oil has long been a key support for emerging economies, but prices are declining as war draws closer, apparently ending a drawn out period of geopolitical uncertainty.

Oil exports support Russian and Mexican government finances, whose bonds together are more than 40 percent of key emerging bond indices. A host of smaller credits also depend on oil.

"Credits like Russia, Ecuador, Venezuela, Mexico, Ecuador, Kazakhstan, Nigeria are going to experience changing perceptions about high oil prices," said Isaac Tabor, emerging market economist at Merrill Lynch in London.

Iraq has the world's second largest proven crude oil reserves and four of the world's top 10 oil exporters are its near neighbours.

Prices for benchmark Brent crude oil peaked at around $34 per barrel in early March, after climbing steadily since November, when the United Nations passed a resolution giving Iraqi President Saddam Hussein a final opportunity to disarm or face "serious consequences".

Iraq denies having weapons of mass destruction.

The U.S. has set a deadline of 0115 GMT on Thursday for Saddam and his sons to leave Iraq or face war, an offer Saddam has rejected.

BEWARE SLIDING OIL

"The first reaction on Russian bonds is going to be negative if the price fall is very sharp," Tabor said.

Russia's Urals crude benchmark has already fallen fast. At around $26 per barrel on Wednesday, it is now well below its March 10 peak of $33.54 per barrel.

Russian debt has already slipped a little. Its benchmark 2030 dollar bond <RUSGLB30=RR> was trading at 85.25 percent of face value on Wednesday, about two points lower than before oil prices began their fall.

But analysts said that even with a tumbling oil price, the Russian economy was unlikely to experience the sort of crisis that led to a painful currency devaluation and debt default in 1998.

"Russia should be well protected. Oil could go down to $14 or $15 per barrel, before it would hit fiscal or balance of payments difficulties," said Peter Botoucharov, emerging market economist at Commerzbank in London.

BEWARE FALLING T-BILLS

A quick war, which is widely forecast, is also likely to trigger a sell-off in safe-haven assets, including U.S. Treasury debt.

Treasury yields have already begun rising, with investors switching into rallying equity markets, after shrinking to historic lows as the threat of conflict in Iraq grew.

"The main risk (for Treasuries) is a super-sharp recovery in equities," said Michael Ganske, emerging debt fund manager at DWS Investments in Frankfurt.

But a prolonged equities rally could also pull cash out of emerging debt, which has benefited from buying by investors seeking higher returns than those offered by Treasuries, but unwilling to plunge into a very bearish stock market.

A Treasury sell-off could also have a secondary effect, in that it would reduce the value of collateral attached to some emerging market bonds, dulling their appeal for investors.

Brady bonds make up a large portion of the emerging debt market, including Brazil's C bond <BRAZILC=RR>, the most traded emerging debt instrument.

Named for former U.S. Treasury Secretary Nicholas Brady, such bonds were issued under a scheme to ease developing countries' debt burdens by repackaging defaulted loans into tradable bonds backed with U.S. Treasuries.

Collateralisation has helped boost demand for such debt this year, pushing prices higher.

Brazil's C bond has climbed to 78.125 percent of face value, up from 66.5 percent of face value at the start of the year.

Analysts said domestic investors especially were likely to sell if they saw Brady bonds losing value, even if the fall only reflects a slide in the U.S. Treasury collateral, rather than a higher perception of risk regarding the issuing country. "If Treasuries sell off massively it could trigger strong selling, because the locals trade on yield," said DWS's Gankse.

"For the local investor that is negative price action. They may get nervous and sell, (and) that could produce the momentum for a sharp sell off."