Black Swan?

The past couple of days remind a lot of when those Bear Stearns Credit funds went under: massive panic about something in an esoteric corner of the market that was viewed as being a non-issue appearing on the front page of the FT & WSJ, followed by dip-buying off the lows as participants attempt to shrug off the news.

I'm sure you'll remember that Suprime was considered to be "contained" (I think that was the choice phrase) and would not be a broader issue for markets. Indeed, $250bn of securities were clearly not enough to land the financial system with $3trn of losses. But what did happen was that market participants were forced to do their homework and did not like what they saw. The point being that there were wider issues that were brought to view and the events in themselves led to large strains across various segments of the financial system.

The reason I bring up this similarity is that an excellent article (from the good people at Nomura) I read today hit the nail on the head: this is a BLACK SWAN. It points out that the issue here is willingness to pay, not ability to pay. And that, I think, is the heart of the matter. The UAE clearly has ample amounts of money. The last time a sovereign defaulted from being unwilling to pay was Equador a couple of years ago (recall Chavez's socialist revolutions across South America) [and of course Russia in 1998]. But Equador is an irrelavent country on the periphery and that was at a time when the banking system was not in a bad state.

Dubai is different because the West is exposed to it in not insignificant size. Sure, the size in itself is not an issue (just as $250bn of subprime securities were not an issue in themselves for the banks), but I would draw attenion to the willingness to pay issue. Sovereign defaults usually occur when either a country has an inability to pay, or the market believes them to have an inability to pay - there is a classic-style run on the capital account and a crisis ensues. In recent years there have been very few countries that fell into this bracket (the Baltics, Iceland) as most EM countries have built up very large FX reserves in recent years (in addition, the presence of China has ensured that commodity prices - EM countries' main exports - have remained high, thus reducing the risk of a balance of payments crisis). So EM countries have the ability to pay, but do they all have the willingness to pay?

What I am trying to say is that is this event going to force market participants to re-examine EM risk premia? I don't think that it is a scenario that can be ruled out.