The Euroblonde

A debt trap if there was one

Only a night before Eid-ul-Azha, the nation was preoccupied by festive frenzy when Pakistan issued the 10-year, $500-million Eurobond at a staggering yield of 8.25 percent, limiting itself to the original target instead of the expected $1 billion. The high cost of servicing this debt was primarily the reason due to which hell broke loose on the finance team before they could even fly back to Pakistan after a series of road shows in the United States.

In April 2014, the last dollar-denominated sovereign bond issued by Pakistan fetched the highest amount that Pakistan has ever raised in a single attempt from international investors, slightly over $2 billion. The government raised $1 billion through five-year bonds at a fixed rate of 7.25 percent, which was 558 basis points above the benchmark five-year US Treasury rate. The remaining $1 billion was generated through 10-year bonds at a fixed rate of 8.25 percent (rate same as this year), which was 556 basis points above the corresponding 10-year US Treasury benchmark rate.

The higher-than-benchmark rate is attributed to the ‘premium’ that Pakistan must pay on its sovereign bonds in order to generate investor interest, given that investment in Pakistani bonds is riskier than that in the US treasury instruments. The rule of thumb states: the greater the risk, the greater the premium.

This time, the 10-year sovereign bond was issued at an incredible 612bps over and above the 10-year US Treasury benchmark rate. What we need to understand here is that the coupon rate for the newly issued 10-year Eurobond is not the same 8.25 percent but there is an increase of an added 56bps premium compared to only last year, which is now an added cost that Pakistanis have to bear to service this external debt.

It is very clear that investor’s sentiments about the health of Pakistani economy in the international markets compared to its peers have taken a reverse gear. The credit default swaps (CDS) acts as a hedge against sovereign debt to eliminate possible loss arising from default by the issuer of the bonds. It was only this year in February when Russian debt issuance cost and yield spreads on sovereign dollar bonds surpassed those of Pakistan’s, whose credit rating was several notches lower. But now hardly in seven months Pakistan’s credit default swaps have risen all the way from around 450bps to currently hovering around 650bps! This means the lenders seems more skeptical about Pakistan’s outlook hence demand a greater percentage to hedge their exposure.

On the other hand, Kenya did its first ever issue last year and raised $1.5 billion at a yield of 6.875 percent and Sri Lanka just a few months back raised $650 million at a pricing of 6.125 percent which is more than two percent lower than what Pakistan is going to pay, which has raised several questions.

Let’s have a look at a few factors which helps us bust this myth of added 56bps premium:

Reasons for issuing Eurobonds:

To run an economy, you need money and when you don’t have it you need to either print it or borrow it. Printing money comes with its serious predicaments, the reason is that printing money doesn’t increase economic output in any way – it merely causes inflation. The next option is to borrow money. The government has been exploring possibilities of financing its deficit from multiple sources namely, IMF, World Bank, domestic borrowing and now it has found the easiest, yet extremely expensive, solution of all, Eurobonds.

Last year the reason given for issuing Eurobonds was an effort to “re-enter the international markets” but as I see it; it was a desperate measure to catapult faster than ever depleting foreign reserves by the finance minister. This time the ministry was very vocal about its intentions of taking the most expensive route to borrowing money which was “to cover the forthcoming maturity in March 2016 of a bond issued in 2006. This means Pakistan’s exchequer does not hold enough money to pay back its liability due in only five months! The country clearly appears to be in a debt trap, where the government is meeting its debt servicing requirements by borrowing more. A reason like this in place puts the lender at an advantage to demand a premium of choice.

Sources of funding

Debt is mainly categorised into domestics and external. The current regime has more lately exhausted the domestic borrowing option or rather stretched it to the limit where PIB holdings by commercial banks in Pakistan (including 10-year sovereign bond) have reached record high levels. Whereas on the macroeconomic front, the prevailing interest rates in the economy have reached their lowest level since 42 years due to which it is not lucrative for domestic lenders to lend the government any more money for their long term borrowing needs. Hence the government needed to find other sources of borrowing. The IMF has been extremely rigid when it comes to general terms and conditions surrounding its loan policy and the government has struggled to pay its short terms installments in the past. Taxes and privatisation receipts seem to have lost the handle already. Knowing that beggars can’t be choosers the government was left with no option than to go off shore to borrow in the international open market commonly known as Eurobond.

International loans are more expensive than domestic loans. The government is fearlessly increasing international loans and hence the loan portfolio is tilted towards expensive sources of funds. The implications will be felt in later years. The SBP has spelled out reasons to issue this Eurobond at 8.25 percent citing “weak market conditions” but what we need to understand is that even these eurobonds will eventually be paid off in dollars. So the government earns in rupees but pays the loans in dollars and that too at future prevailing rates in 2025; it is anyone’s guess what would be the dollar rate 10 years down the road.