Banana Republic Watch: Credit Default Swaps on Russia Cheaper Than on California

Oh, there is nothing like a global retreat of liquidity to reveal who was wearing a swimsuit. And what wags like Warren Buffett fail to add, when a lot of people were found to be unclad, you also get to see who looks best of a typically not so fetching bunch.

In this case, California is being deemed a worse credit risk that Russia. Of course, that view would change quickly if oil prices were to decline sharply, as some observers like Philip Verlegger predict. But this isn’t a fluke. Many emerging markets credits now have CDS spreads below that of many states and New York City.

From Bloomberg (hat tip DoctoRx):

Investor demand for emerging-market bonds is driving the cost of insuring against debt defaults below industrialized governments for the first time.

Credit-default swap prices from Turkey to Indonesia are falling as bonds rise amid signs that their economies are recovering faster than developed nations. As the U.S. and U.K. borrow record amounts to fund bank bailouts and stimulus, Brazil, Russia, India and China have $3 trillion in reserves, up 19 percent from January 2008 and now 43 percent of the worldwide total, data compiled by Bloomberg show.

The annual cost of protecting holdings in Turkey’s bonds fell by half to $200,000 per $10 million for five years, or 200 basis points, sinking below New York City swaps for two weeks starting July 22, Bloomberg data show. Indonesia debt insurance dropped below Michigan the next day. Brazil swaps just had their biggest four-month slide ever. For China, protection is near the cheapest in a year. Eleven years after Russia defaulted, investors want less to insure its debt than California’s.

“This would have been impossible to imagine a year ago,” said Dmitry Sentchoukov, an emerging-market credit strategist at Dresdner Kleinwort in London. “Now it’s clear emerging economies are going to outperform the Group of Seven in growth, and that makes investors comfortable with the idea that developing countries can be priced richer than developed.”…

The average cost of swaps for sovereign debt from 45 developing countries has declined to 314 basis points, the lowest since October, from 785 basis points five months ago…. Emerging-market bond funds held almost $49 billion on July 31, the most since October, after their biggest weekly cash influx in a year. They’ve attracted more deposits than withdrawals every week since April 13, following eight months of declines, said EPFR Global, a Cambridge, Massachusetts, researcher…

Emerging economies probably will expand 1.5 percent this year and 4.7 percent in 2010, the International Monetary Fund forecast July 8. Developed economies likely will shrink 3.8 percent in 2009 and grow 0.6 percent next year, the IMF said. The U.S. is in its worst downturn since the 1930s with consumer spending, 70 percent of gross domestic product, dropping at a 1.2 percent pace in the second quarter…..

Swaps on California have risen more than three-fold in the past year as its credit rating was lowered two levels to Baa1 by Moody’s, the same level as Russia, which reneged on $40 billion of sovereign debt payments in 1998. Russian default swaps are near a 10-month low of 255 basis points, about 20 basis points less than contracts linked to California. The former Soviet state’s 7.5 percent, 2030 dollar bonds are at a 2 1/2-month high of 101.74 cents on the dollar.

“If California is issuing their own dummy currency in the form of IOUs, that’s not a good sign,” said Augustus’ McNamara.

Russia has an “extremely low” debt-to-GDP ratio of about 10 percent which is attractive to “any type of bond investor,” said Luis Costa, an emerging-market debt analyst at Commerzbank in London. “For as long as U.S. municipal and state governments are in trouble, I think this trend will continue.”…

“This trend of lower sovereign spreads will continue,” said Richard House, who manages $1.1 billion in emerging-market debt at Threadneedle Asset Management in London. “Balance sheets are so strong now and most governments don’t need to sell debt in the external markets.”….

Swaps for New York increased more than three-fold in the past year. The world’s financial capital, rated nine levels higher than Turkey by Moody’s Investor’s Service at Aa3, faces unemployment close to 10 percent and reduced tax revenue from Wall Street firms. New York City Mayor Michael Bloomberg is founder and majority owner of Bloomberg News parent Bloomberg LP.

As emerging-market bonds rally and swaps plummet, stocks from those economies are leading a climb in global equities. The MSCI Emerging Market Index has added 51 percent this year, compared to a 15 percent increase in the MSCI World Index of developed stocks.

McNamara of Augustus Asset Management said he has reduced his investments in credit-default swaps this year because they are less liquid than bonds and have higher capital requirements and regulatory risks.

“They have lost their competitive advantage to bonds,” he said.