By Peter Apps
LONDON, Sept 15 (Reuters) - The unwinding of failed U.S. bank Lehman Brothers' trading positions in often illiquid emerging markets could prompt further problems for developing economies struggling with a devastating range of issues.
Having been described as "decoupled" or insulated from global financial and economic worries until just a few months ago, emerging markets have been pounded by the impact of rising risk aversion, a U.S. dollar recovery, retreating commodity prices and political stresses such as the Georgia war.
But Monday's news Wall Street's fourth-largest bank Lehman Brothers <LEH.N> was filing for bankruptcy protection and the sudden sale of Merrill Lynch <MER.N> to Bank of America has made even bearish analysts suddenly feel they had been optimistic.
"We thought some of the central European countries were going to get in trouble on their own with their large current-account deficits," said Lars Christensen, emerging market strategist at Danske Bank.
"If the biggest financial institutions in the world can't cover themselves in this situation it is much worse than we thought."
Benchmark emerging equities <.MSCIEF> lost more than 2 percent in European trade, now down roughly 33 percent so far this year at their lowest levels since 2006. Emerging sovereign debt spreads <11EMJ> widened a dramatic 25 basis points to 359 over US Treasuries.
But analysts expect potentially dramatic impact on individual markets as Lehman unwinds and sells positions in an environment where there may be few enthusiastic buyers even at deeply discounted prices.
Lehman were not one of the world leaders in emerging markets but their positions could still run to several billion dollars, analysts say. A Euromoney survey showed their foreign exchange market share in Asia jumping last year. In shallow markets, their impact would still be sharp.
SAVAGE MOVES?
In principle, if Lehman had been shorting a position in an emerging country then unrolling that position could push the market higher, albeit possibly only briefly.
"You could get some very savage moves in either direction," said Foreign and Colonial emerging equities head Jeff Chowdhry.
They say speculation about where those might be would likely drive market volatility in the coming days and weeks until it was clear the positions had been unwound.
Commerzbank debt strategist Luis Costa said Merrill Lynch's new owners might also unwind some of its positions, further boosting the impact.
"These guys were very active in central and eastern European markets," he said. "We are talking about huge books which are going to have to be closed."
That would likely include Russian stocks and other assets, he said. Russian markets have been pounded in the last two months by retreating commodity prices, the impact of war with Georgia and worries over government interference in investments.
But analysts say smaller eastern and central European markets from the Baltics to Bulgaria and Romania may be more exposed, with their sheer shallowness exaggerating any impact.
ALREADY HURTING
In some cases, analysts say selling off the assets could be hard to do if buyers are simply too reluctant to emerge.
Even before the demise of Lehman, data from Boston-based fund tracker EPFR Global showed outflows from emerging market bond and equity funds at $29.5 billion over the last three months, the highest since 1995, with withdrawals increasing over last week.
U.S. investors have been liquidating overseas positions and bringing their money home, giving the U.S. dollar a counter-intuitive boost against other global currencies.
That in itself will worsen the position of emerging borrowers -- particularly corporates -- who will find the amount of debt they have to repay rising as their currencies sink or targetted or pegged exchange rates come under strain.
U.S. investors may not be the only ones keeping their money closer to home, with some of the sovereign wealth funds built up by commodity producing and goods exporting emerging market countries also holding back.
The Qatar Investment Authority said it would wait and see before them making any new investments in U.S. markets [].
Russia's Interfax news agency quoted finance minister Alexei Kudrin as saying Russia would invest its National Wealth Fund in foreign stocks and corporate bonds only once the world financial crisis was over [].
Russian officials had already touted the idea of using national wealth to prop up their own domestic financial markets.
But not everyone is gloomy.
"We believe that after all these falls in emerging markets are beginning to once again offer very good value for money," said Foreign and Colonial's Chowdhry.
(Editing by Ron Askew)
