Emerging market debt on U.S. Treasury widening; Philippine's Arroyo calls special session on VAT

By Reshmi Basu and Paul A. Harris

New York, March 18 - Emerging market debt ended Friday lower as U.S. Treasuries were weaker in response to further economic data in the United States.

Adding more jitters to the Treasury market, imported-good prices increased by 0.8%, higher than expectations. Rising crude oil prices were blamed for the rise.

Emerging markets activity was distinguished by volatile trading as early gains were erased.

The Brazil C-bond was down ¼ of a point to 100 bid while the bond due 2040 slipped 0.40 to 112¾ bid. That bond had been up by 0.10 earlier in the session.

The Russia bond due 2030 slipped 0.505 to 102.07 bid. The Venezuela bond due 2027 dropped 1.7 to par bid.

Overall, the JP Morgan EMBI+ was down 0.24% while its spread to Treasuries narrowed by one basis point to 363 basis points.

Flight to quality

"Trading has been light on generally negative sentiment," said a market source.

"People seem to expect the spread tightening trend, which has now prevailed for quite a while, to reverse.

"That may result in a flight to quality that could have a negative impact on emerging markets credits."

The past week has seen some balance sheet reduction, said a debt strategist.

Whether the trend is temporary or long-term problem is the "$100 question", he noted.

"It does not look to have the same magnitude as the panic we saw last May. It seems to still be on-the-margin activity."

Positive technicals within emerging markets should keep investors from revisiting last May's bloodshed, according to the strategist.

He added: "I still think there's awful lot of liquidity out there."

Nonetheless, emerging markets did experience something of a flight to quality in the last week. Inflows were at $126 million in the week ending March 16, according to EmergingPortfolio.com Fund Research. While $126 million is a solid number, it fell short of the $497.7 million of inflows seen the week before.

But the strategist still expects inflows to be good, citing the Brazilian spot exchange rate as a gage.

"It's actually stronger over the last two days - dramatically stronger than it was on its weak points. That's a very key kind of canary in the mineshaft."

Brazil on a new fiscal path

In regards to the Brazilian story, the debt strategist had a concern, that the government over-relied on the central bank to curb inflation.

"The external story still seems solid," said the strategist.

But the fiscal story looked a little complacent, he noted.

"Government spending was moving up fairly strong. They seemed to be leaning entirely on the central bank to deal with inflation."

On Wednesday, Brazil's monetary policy committee raised interest rates one-half percentage point to 19¼% for the seventh straight time.

"Now there seems to be something new in the woods," said the strategist.

"What we see is different is that now we have the interest rate at 19¼%. Everyone is saying, 'You know there is a fiscal cost to having only monetary policy. Do you think it's time to revisit your thoughts on the primary budget surplus?'

"I think that's an idea that may be getting some traction."

The strategist added that he would not be surprised if the government announced a roll back in rates or spending cuts, or measures along those lines.

Philippine's Arroya calls special session

On Friday, Philippines president Gloria Arroyo called congress to a special session in order to pass a bill restructuring the value-added tax system. The tax bill is seen as crucial in slimming the country's budget deficit.

Despite the need for a special meeting to try to get the changes through, Philippines bonds have held their own amid the recent sell-off in emerging markets, widening an average of 26 basis points versus a 30 to 40 basis points widening in other benchmarks issues.

"There's still a lot of hopefulness about the Philippines on the fiscal side right now, and I think a lot of the investors who bought the improving fiscal story back in January and February are still holding on, hoping that the reforms are going to pass," said an emerging market analyst.

"But you have to ask yourself, why hasn't the VAT reform passed already? Why does Arroyo have to recall Congress out of its Easter break, and is there any guarantee that they will get the reform passed during the special session?

"I think Philippines external debt is still very vulnerable to fiscal setbacks, especially in this choppy overall EM environment," he added.

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