A blazing regional dispute between Colombia, Ecuador and Venezuela this week has triggered investor fears that political risk premiums may once again drive capital volatility in the region at a time when liquidity is already tight.
A Colombian raid on Ecuadorian soil killed 17 senior members of the Revolutionary Armed Forces of Colombia (FARC) over the weekend, provoking an unprecedented diplomatic spat and arousing fears over commercial relations in the region.
Tensions were heightened further on Wednesday after president Hugo Chávez mobilized 10 army battalions along the Venezuela-Colombia border, blasting Bogotá’s ‘war crimes’.
Chávez claimed this was a preventive measure against any potential Colombian incursion, while closing its embassy in the country’s capital, and threatening to seize assets of the neighbouring nation’s companies - an historic deterioration of relations.
In a further escalation of regional hostility, FARC yesterday (Thursday) bombed the Transandino oil pipeline in Colombia’s Putumayo province.
In response, Venezuelan assets suffered a hit this week with five year CDS rising 6bp to 613bp, the highest since July 2004.
Yet despite fears the Andean region is on the brink of war, Colombian and Ecuadorian bond performances saw only modest losses.
Ecuador's five-year CDS rates widened by 12.8bp to 660.106bp, while Colombia CDS improved yesterday tightening 2.2bp to 203.53bp.
Yet the economic risks are high. Colombia sold $1.2bn of goods to Ecuador in 2007 and supplies a third of its energy.
Crucially, one-third of Colombia’s manufacturing exports are despatched to Venezuela.
However, regional commercial ties have in fact reassured market participants that a continuation of the political standoff would be against the economic interests of the parties involved.
“There is no reason to expect the Colombian economy to collapse or the world community will take a strong position against them despite what has happened,” said Alberto Bernal, Latin America fixed-income analyst at Bear Stearns in New York.
“The market is taking this view as evidenced by Colombia’s bond performance this week.”
Nevertheless, Merrill Lynch argued that the conflict is a significant “source of ongoing risk for Colombia assets” and potential trade restrictions would be a threat to the Colombia peso and holders of its 2017 peso-denominated notes.
Bernal cautioned: “Ecuador could be subject to problems and put under pressure if the government of Colombia presents unequivocal proof that the administration of President Rafael Correa has been shielding the terrorists,” - although he believes such risks are currently limited.
However, a military confrontation could undermine Ecuador’s path to debt sustainability and harden the political resolve to default on foreign debt.
A committee set up in July 2007 ruled that Ecuador’s 2012 and 2030 global bonds “illegitimate” because it was contracted as part of corrupt deals by previous governments.
“If there is a war in the Andean region, you can be quite certain that Ecuador may decide not pay its debts,” Bernal argued.
A regional confrontation would diminish Correa’s political and economic capital to repay.
Nevertheless, foreign investors are still broadly confident with Andean risk, banking on high commodity prices offsetting poor governance and financial mismanagement in Ecuador and to a lesser extent Venezuela.
But in this current market distress and tightened liquidity, political risk could re-emerge as a significant driver of sovereign risk premiums in Latin America, Western bankers suggested.
“These events reminds us that we are dealing with developing economies after all and we have stop lulling ourselves into false confidence that politics no longer matters,” said one DCM head.
Observers say sovereign spreads are now at artificially tight spreads driven by the scarcity of international benchmarks after numerous debt buybacks by regional governments, and investors seeking to step up exposure to defensive emerging credits.
Clearly, bonds such as Brazilian 2040s – the most liquid benchmark in the region - is unlikely to be held hostage to localized political events.
But there are still question marks over whether the out-performance of LatAm sovereign notes generally is sustainable.
“These events does bring home the message that while we have experienced tremendous global growth, good economic policy in the region and relatively benign political dynamics – things could easily change by unpredictable contingencies,” said one bond syndicate head.
Furthermore, as investor fears over economic policy direction in the region has gradually abated, this should have raised the prominence of political risks to the fore, as a simple function of traditional emerging market risk analysis.
“These events have brought my perspective on the region into focus. Clearly, we have a shift of risks in Latin America from them being largely economic or liquidity driven events such as Mexico’s Tequila crisis to political issues now, rather than fears over economic fundamentals”.
This week’s Andean crisis may have now jolted investors and bankers to consider political risks once more.