On Sovereign and Quasi-Sovereign Risks

I like investing internationally, because of the diversification it offers, both in stocks and bonds.  Or, think of it as a hedge.  Will the American Experiment continue to prosper?  We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.  I have two requirements.

  • Contract law must be close to that in the US, or better.
  • Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.  There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.  My acid test is watching over a long period and seeing how they treat foreign shareholders.  That is a good measure of the morality of management.  If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

  • Russia
  • China
  • Most of the Middle East.
  • Venezuela
  • And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.  It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.  Don’t buy pigs in pokes.

This has application today with Dubai.  The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.  This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.  Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.  This incident will prove instructive on how these bonds keep or lose value in a reorganization.  What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.  Personally, I never found them compelling, and probably won’t in the future.  There is something compelling about straight senior unsecured debt that pays interest.  I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.  Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.  Even if you personally have the fortitude to do so, there may be others that influence you that don’t.  (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.  Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.  When I was younger, I thought the great risk of the Euro was that it would be too weak.  Bite my tongue.  The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed  skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.  That bias is largely gone today, after a period of few sovereign losses.  Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.  Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.  If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.  On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.  With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.  Not a strong bargaining position in my opinion.  The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.  What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.  Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.  Character is important in any credit decision, and the government of Dubai does not have good character in my book.