Ecuador's Default Threatens to Provoke Wider Tumult

In pushing for repayment, Brady Bond market investors are hoping to contain a potentially significant loss and keep Ecuador's action from setting a dangerous precedent.
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The Brady Bond market may appear to be taking Ecuador's partial default in stride, but don't be fooled. Investors are not only troubled by Ecuador's action, they are forcing an accelerated restructuring that will ultimately serve to keep Brady prices at current depressed levels for months to come.

Since Friday, when Ecuadorean bondholders demanded immediate payment on $1.4 billion in discount Bradys, the price of Ecuador's past due interest Bradys have hovered at about $20.25 per $100 in face value for a yield of near 38%. Six months ago the bonds traded at about $45.

Holders of Ecuador's discount bonds have pushed for a speedy restructuring not because they think they can get their hands on nonexistent cash -- they understand Ecuador is broke and has been for a long while. What worries them is that Ecuador has discriminated between collateralized and noncollateralized debt, a distinction that has the potential to spill over to other countries' debt instruments, particularly pars and discount Bradys. In the worst case scenario, collateralized debt would be forsaken and financing costs across Latin America would rise.

"It is no coincidence that Mexico, Venezuela and Brazil are exchanging their Bradys for other debt. The benchmarks set by Bradys, at the more realistic yields, are too wide to allow for good financing," said Jose Gonzales, Latin American equity strategist at

Credit Lyonnais Securities

.

While no country is close to Ecuador's insolvency right now, Bradys should continue to stay at wide yield spreads until the bonds mature over the next five years and countries switch into lower interest instruments, analysts say.

In the meantime, investors in the region are viewing Ecuador as a potential script for possible problems in the future. The country has effectively given up any hope of further credit. Holders of other Ecuadorean debt will most likely push for restructuring of all the country's outstanding debt since to pay one class and not others would set the country up for legal difficulties. Thus, a cycle of cross-defaults is all but guaranteed, leading Ecuador, laden with Latin America's heaviest debt burden, to seek last resort financing from institutions like the

World Bank

or the

International Monetary Fund

.

"If we were in a better economic situation, we could pay on our bonds as they come due," said Juan Montufar, Ecuador's debt negotiator, on Tuesday. "The question is, how will we restructure the new terms? We have no clues to that yet."

Within three weeks, Ecuador's government will present its restructuring plan, which, according to Finance Minister Alfredo Arizaga, will include a bond swap proposal and a restructuring of its $2.6 billion of domestic debt, $1.2 billion of debt owed to the

Paris Club

, a group of creditor nations, and $500 million in outstanding Eurobonds.

Ecuador's financial situation will only worsen as trade financing is cut and the government remains unequipped to handle the situation, warns Credit Lyonnais's Gonzales. "Ecuador," he says, "is condemned to live in the economic Middle Ages."

The

Moody's Investors Service

downgrading of Ecuador's foreign currency debt ceiling and deposits to Caa2 from the already junk-rated B3 failed to push Ecuador's Bradys any wider. Collateralized par and discount bonds were also downgraded to Caa2. Noncollateralized past-due interest and interest equalization bonds and Eurobonds were downgraded to Caa3.

"Given the high likelihood of a further deterioration in Ecuador's domestic economic and political conditions, and the possibility of protracted litigation resulting from the recent defaults and investor demands for acceleration of payment, the ultimate loss for investors could be significant," wrote Moody's in its report.

The lack of investor flight following such discouraging comments demonstrates how much risk has already been factored in. Upcoming regionwide elections, Y2K worries and Ecuador's insolvency are but a handful of the many regional risk factors that have been priced into the battered bonds following last year's Russian collapse.

With the Ecuadorian default precedent in place and the "bailing-in" principle (private sector involvement in preventing and resolving economic crises) of the IMF now in question, investors will be holding their breath over the next few years to see who will be the next to push the debt envelope and try investors' patience.

"This is unprecedented. Unfortunately we are the leaders," lamented a somber Pablo Better, president of Ecuador's central bank at last week's World Bank annual meetings. "Others will follow."