Emerging market debt weaker on Brazilian contagion effect; Ecuador down hard

By Reshmi Basu and Paul A. Harris

New York, July 25 -Emerging market debt slid Monday in response to the ongoing political scandal in Brazil, which is sending quivers across the asset class.

The market is jittery as the "bribes for votes" scandal refuses to disappear, said sources.

Leaders of president Luiz Inácio Lula da Silva's Workers Party (PT) have admitted to irregular campaign financing, which has resulted in the worst scandal to hit Lula's presidency.

At first, Brazilian bonds had shown resilience in the face of the crisis, as Lula appeared insulated. But as some of his closest advisers resign, the fear is that Lula will be dragged into fray.

"It seems to be that Brazil has a very large political component that seems to be factored into local markets," said Enrique Alvarez, Latin America debt strategist for IDEAglobal.

"Brazil's political noise doesn't seem to want to go away. The more drawn out it becomes, the higher the danger that you will have [finance minister Antonio] Palocci or Lula directly smeared by some of the stuff being thrown around," he said.

He added that across the board, Brazilian markets took a beating on the negative sentiment. For instance, the Brazilian real fell 3.8% against the dollar and the Bovespa fell 3.4%.

Across the Brazilian debt curve, prices were weaker. The bond due 2009 fell 1¼ points to 128 bid while the bond due 2012 slipped 1.15 points to 117½ bid. The bond due 2040 dropped 1.70 points to 114.85 bid.

Furthermore, Alvarez added that the Brazilian market jitters are starting to trickle into other parts of the region, bringing down high-beta credits.

"The Merval in Argentina - that's off nearly 2%," he noted. The Bolsa in Mexico has come off almost 1%. And the Mexican peso has also gotten killed.

"I think the nervousness in Brazil is at least motivating some profit taking elsewhere in Latin America," he added.

During the session, the Colombia bond due 2007 fell 1¾ points to 103 bid while the bond due 2033 lost 0.90 to 115.60 bid. The Mexico bond due 2009 slipped a quarter of a point to 117¾ bid. The Venezuela bond due 2027 dropped 1.45 points to 102¼ bid.

Ecuador down hard

However, Ecuador surfaced as the loser of the session. The Ecuador bond due 2012 fell half a point to 97¼ bid while the bond due 2030 plummeted three points to 83 bid.

Ecuador fell victim to a confluence of events, noted Alvarez.

"You have a Brazil, which is in the same high beta camp as Ecuador, sort of bowing under pressure. People tend to sell what they consider high risk immediately."

In April, Ecuador's paper was crushed in response to the ouster of ex-president Lucio Gutierrez. But the paper had since rebounded.

"I think people are beginning to realize that we may be repricing higher risk instruments...which means that Ecuador would probably need to widen after tightening in the last few weeks," remarked Alvarez.

Meanwhile president Alfredo Palacios' partial veto of a plan to return reserves to contributors of social security is another reason why its bonds are under pressure, said Alvarez.

The market wanted an all-out veto.

Another issue that may pop up is that ex-president Gutierrez wants to re-enter the country.

"He's in Peru and is making a lot of noise," remarked Alvarez.

"He attempted apparently to cross the border into Ecuador."

C bond call expected

Meanwhile last week Brazil swapped $4.4 billion, or 79% of its outstanding 8% bonds due 2014, the C bonds it issued a decade ago as part of a debt restructuring, a source recalled Monday.

The new securities, which have the same coupon, are due slightly less than four years later.

Many observers are anticipating that Brazil will call the remaining $1.2 billion of C bonds in October. Most of those bonds are now in the hands of Banco do Brasil, the source said, adding that the remaining C bonds are liable to trade lower because of the lower liquidity of the dramatically reduced issue size as well as the anticipated call.

The source estimated the probable call price at 101.0 maximum.

In early Monday trading the new Brazil 8% bonds due 2018 were up slightly at 100.75 bid, while Brazil's 2040 bond was 116.50, down 25 basis points.

At the end of the session, the C bond was down a quarter of a point to 101¼ bid.

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