Emerging market debt hit by yuan revaluation, London explosions; EM sees inflows of $132 million

By Reshmi Basu and Paul A. Harris

New York, July 21 - Emerging market debt saw tighter spreads but lower prices Thursday, as two headlining stories dominated the market.

Meanwhile, mutual funds saw inflows of $132 million during the week ending July 20, according to EmergingPortfolio.com Fund Research.

This is the fourth straight week of positive flows into the market. Funds now have $4.282 billion of inflows year-to-date.

Yuan valuation

In what some sources called a political move, Beijing revealed plans to revalue its currency.

The People's Bank of China said on its website that it was dropping its yuan to dollar peg in favor of one tied to a basket of currencies.

Additionally, the government raised the value of the currency by more than 2% to 8.11 yuan per dollar.

That news caused U.S. Treasuries to sell off on concern that China would buy less U.S. bonds. China is the second-largest holder of U.S. Treasuries, following Japan.

"Obviously, we expect to see China to keep the basket at 8.11," said a sellside source.

"So for now, it's just a 2% appreciation of the yuan. That just means that maybe they will buy less Treasuries...to maintain that peg.

"But they're still going to have to buy," he added.

EM prices down

Nonetheless, the yuan revaluation story put pressure on emerging markets via the Treasury market, said sources. Also adding stress was the news of more bombings on London's transit system.

However, the direct impact on emerging markets was muted as spreads on the JP Morgan EMBI+ Index tightened by eight basis points.

"The only thing here is Treasuries are much higher," said a sellside source.

The yield on the 10-year note stood at 4.28% compared to Wednesday's close of 4.18%.

"If you strip out the impact on the Treasury market it's net-net a positive," said a trader.

"However if there is heightened volatility in the Treasury market, I think that's going to take some of the steam out of things," he said.

Another trader said the impact was small for Asian paper. Although prices were down, spreads were tighter on Asian names.

"The technical backdrop of the market is stellar. The blunt of the announcement is seen in the Treasury market," remarked the trader.

The Korea bond due 2008 was down 0.20 to 111.846 bid while the bond due 2014 slipped 0.80 to 99.434 bid. China paper due 2006 was down 0.04 to 103.214 bid while the bond due 2014 lost 0.87 to 99.576 bid. The Indonesia bond due 2006 fell 0.02 to 101.685 bid.

The first trader said that in the long term the yuan revaluation should benefit Asian credits for the most part.

Other Latin American names were under pressure as well. The Brazil C bond fell 0.56 to 101.56 while the bond due 2040 slid 0.90 to 117.40 bid. The Mexico bond due 2009 lost 0.45 to 118 bid. The Venezuela bond due 2027 dropped ¾ of a point to 104½ bid.

Political move?

Some members of Capitol Hill have been pushing for tariffs on Chinese imports, saying that pegging the yuan to the dollar gave China an unfair pricing advantage.

"We think it's more like a political move, so [China is] not to be tagged as the currency manipulators," added the sellside source.

The source said the decision must be political, given that one-hour after China's announcement, Malaysia ended the ringgit's peg to the dollar.

"They [Malaysia] couldn't do that unless they were coordinated," he replied.

The yuan news came as no surprise to one debt strategist, who said that he had been expecting such a move.

"In our global portfolios, we own a number of the Asian currencies, so we had a good day that way. We don't think it's over. We think they're going to let things just creep ever so slightly stronger," he said.

It makes sense for China to let the currency edge higher, given that reserves are strong, remarked the strategist.

On a political note, it is the line of least resistance, added the strategist.

Election season starts in Brazil, says strategist

As each day passes, more allegations of political corruption surface in Brazil, which in turn is weighing down the country's debt.

President Luiz Inácio Lula da Silva and his governing Workers' party (PT) have been dogged by allegations of "bribes for votes."

"The campaign has started early," noted the strategist.

Historically, when Brazil was under more external financing pressure and when there was a political crisis of this sort, investors tended to sell Brazilian bonds, he said.

"The reason why was that it would lead to policy paralysis and typically the market needed to see something on the policy front to make them feel better.

"At the moment, Brazil is at a current account surplus and reserves have been rising."

Furthermore, macro-economic numbers have been reasonably positive for the country, he noted.

"The difference is that at the moment, Brazilian markets are liquid. In the past, when we had political shenanigans and crises, the market was not liquid and that was a huge problem," he told Prospect News.

The strategist said that given that the market did not expect any new policy developments this year, the market was largely not disappointed.

"But it really raises the question if any of the additional Lula reforms...can possibly be done by now and the next election. Or is everything on hold till the next administration?"

If the latter is true, investors will be looking to see if the government will try to buy its way to popularity.

Meanwhile in the Philippines president Gloria Macapagal-Arroyo continues to battle allegations that she rigged last year's election, which has resulted in calls for her impeachment.

Nonetheless, the country's sovereign bonds have held in well, a surprise to the strategist.

"It goes to show the importance of the remittance flow. Without the remittance flow, the country would be in a crisis," he noted.

Looking ahead, the strategist is monitoring oil prices. Another concern for him is the strength of the global economy.

"We have been on the bullish side of the growth story for the United States. And we are very happy that the Fed came out and say the same thing yesterday [Wednesday].

"That affects us because we've been running our portfolio on a slightly short duration side. The sell-off in the 10-year bond couldn't make us happier," he said.

He added that the next real question is when hot money will move to Asia, which will impact Asian currencies.

"We see things quiet on the South American side," he noted.

Additionally, the surprises in the region will be on the inflation side.

"I think there's been a rotation into expecting inflation to fall in countries like Mexico and Brazil and inflation maybe to move sideways to higher in Argentina.

"And many investors may be in position for both for those trends, so if there's a displacement on either side, people are going to have to restructure their portfolio."

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