The announcement from Jamil Mahuad, the president of Ecuador, that the country would not meet a coupon payment on its Brady bonds due at the end of August and that Ecuador intends to restructure its $13 billion of foreign debt, has dismayed banks and investors across the developed world.
No sovereign has yet defaulted on its already-once-restructured Brady debt. The Brady deals of the early 1990s marked a decisive step forward for many emerging-market borrowers which had defaulted on their bank loans, rehabilitating them into the abundant liquidity of the international bond markets. A Brady default might mark an equally dramatic step back into the dark times.
Dire warnings are being offered to Ecuador: defaulting on bank loans is a mere indiscretion - banks always come back for more in the end - but defaulting in the bond markets might deprive Ecuador of that vital source of financing for decades into the future, perhaps even permanently.
At a stroke, the agenda has been set for this year's annual IMF/World Bank meeting in Washington: what are the consequences for emerging-market borrowers and for private-sector creditors if the world moves decisively into a post-Brady era of sovereign bond defaults?
In truth, few outside the country care much about Ecuador. Its debts are a drop in the ocean of the international bond market. The gloom has spread partly because it simply extends the wearying sense of crisis around emerging markets, partly because it highlights sharply deteriorating economic and financial conditions across Latin America: particularly in Venezuela and Colombia. Most worrying to international lenders and investors: what is the possible reaction of the region's big debtors, Brazil and Argentina? We've seen countries fall one after another before. It wasn't pretty. And the threat of being excluded from the bond markets loses its immediacy - especially to politicians facing re-election - when Latin American governments are already excluded from them, as many will be for the next few months.
But let's try to be grown-up about this. Debtors default: portfolio lenders, both banks and bondholders, know that. The only mystery at any given moment is which debtor will be next, not whether any will fail. After the initial outrage defaulters and creditors do a deal.
Brady bonds were only an evolution in the renegotiating of Latin American debts which really began in the 1980s with that classic form of restructuring known to troubled corporations and homeowners around the world: debt-for-equity swaps.
There is also a practical lesson here concerning the IMF and its relations with the legislators and taxpayers of major donor nations, notably in the US. Since the Asian crisis the IMF has been under intense scrutiny by powerful committees in Congress which have raised doubts about the need for its very existence. The US government has played a double game, being seen to kick the multilaterals by appointing investigating bodies to criticize them, while protecting them by using every trick in the beltway book to sneak legislation through to shore up their funding.
Despite all the gloom, Ecuador may prove to be a useful test case in setting new ground rules on bail-outs and showing that the IMF is not merely a stopping-off point for money en route from taxpayers' pockets to the banks. It has been abundantly clear since the roll-over of Korean debts at the end of 1997, that the US treasury will simply not tolerate the IMF pouring taxpayers' money through the front door of a troubled country, just to see it disappear a few days later through the back door in repayments to western banks. Investors took the high yields and the spread tightening of Brady bonds, plus the comfort from US treasury collateralization of principal - not coupon - payments. Now they can share the pain. Everything else - legal quibbles, questions of bondholder quorums - is just details.
In the rescheduling poker game, banks and investors can of course play the card of prospective unending exclusion from markets. But lecturing is particularly unpalatable from creditors in a country like the US where personal bankruptcy lost its stigma several years ago, where corporate default and recovery rates are measured with scientific precision and where a whole industry has grown up around financing sub-prime, for which read previously defaulting borrowers.
Notions of morality get in the way. This is about efficient capital markets, of which pricing default risk is one aspect. It's a good bet that many of those precious bondholders will turn out to be the proprietary trading desks of the very first-world banks which have been making and losing money by turns in emerging markets for decades. And how many months would Ecuador, or any other defaulting country, really have to wait before announcing the privatization of its telephone monopoly, the sale of a GSM licence, a government-guaranteed bond issue at a big spread over treasuries? The smart suits from Wall Street would be swarming all over them.