A good idea whose time is yet to come

By Mohammed Wehliye

Kenya has a huge infrastructure deficit.

It is obvious that we need to spend a lot of money on infrastructure, i.e. on roads, water and energy, to ensure a steady economic growth.

It, therefore, makes good economic reasoning for the country to borrow from outside to fill the financing gap so as to accelerate economic growth and poverty reduction.

No doubt the proposed $2 billion GoK sovereign bond issuance would be helpful for the country’s economy, if the borrowed fund is spent on such infrastructure projects that offer a greater scope for augmenting revenue earnings and creating employment opportunities.

It is also a step in the right direction for easing pressure on the foreign exchange reserve, enable the government to maintain stable exchange rate, create a vibrant local corporate bond market, and establish a benchmark-bond for the domestic enterprises planning to finance business activities from overseas sources.

The government also intends to use the proceeds from the proposed sovereign bond for partial repayment of some of the $600 million syndicated loan it signed in May 2012.

Will there be demand for a Kenyan bond? Well, there is always the risk of poor response from investors and this largely depends on the timing of the issue.

I doubt whether ours will be issued before end of this year or even early next year’s given the risk of not being able to garner a strong response due to global uncertainties around the unwinding of the US Federal Reserve’s quantitative easing programme expected around this period.

Emerging and frontier market sovereign bonds such as our proposed one have nevertheless been popular because investor opportunities elsewhere are limited.

With quantitative easing having driven interest rates to record lows, developed economies have spurred investors to seek more exotic, high-yielding bonds.

Obscure corners

Almost half the entire global government bonds market is now trading at yields below one per cent.

That has in turn pushed investors into increasingly obscure corners of the financial system, from Rwanda to Mongolia to Papua New Guinea.

Moreover, the conditionality and close monitoring typically associated with the multilateral institutions makes concessional debt, which is cheaper than sovereign debt, less attractive sources of financing to the governments of the developing world.

But is it the right thing to do now? I don’t think the time is apt for a sovereign bond issue.

A sovereign bond issue could compromise financial stability in the future, and the cost of a sovereign bond issue, at least in my opinion, outweighs the benefits at current juncture.

There are a number of reasons why the National Treasury Cabinet Secretary, Henry Rotich, should probably have sat on this one a little longer.

First, the government should work on the basics and explore ways to reduce both the budget and the Current Account Deficits (CAD), including measures to reduce imports, provide incentives and expand exports.

The first step should be to bring down CAD significantly and grow the economy.

We should be doing a sovereign bond issue from a position of strength, when we are much less vulnerable.

Serious external account challenges with worsening trade and current account balances means we need to assess further what impact the bond issuance will have on the balance of payment accounts.

This is very necessary as much of the proceeds are likely to be used to import goods and services and thereby exacerbate the already precarious negative balance of payment situation.

Second, the borrowing costs of the proposed sovereign bond, at least in the short term, would depend on the fundamental conditions in the economy. It normally would depend on three things; the risk of default, exchange rate depreciation and inflation.

As regards the risk of default, Kenya has been rated B+ by both Fitch and S&P.

The sovereign bond yields would thus need to be relatively high to attract global investors.

Any depreciation of the shilling, as also increased inflation levels would substantially increase the sovereign bond yields.

Kenya would thus have to pay a big spread over Libor rate to attract investors. Such high borrowing costs would only exacerbate the problem of external debt and may in future force us to borrow further to service the debt.

Third, Whereas the borrowing would no doubt help bring about a positive momentum to the country’s economy, if the fund is spent on large infrastructure project, there is still the danger that the availability of the bond proceeds is going to affect government spending allocations through “fungibility”, whereby the bond proceeds pay not for items for which they are accounted but for marginal expenditure they make possible.

Inflationary impact

If the sovereign bond directly or indirectly finances the already increasing government consumption expenditure (for instance, salary increases) as against its capital expenditure, then we will be in trouble.

Given that the infrastructure (for which we intend to borrow) would have been financed using budget revenues anyway, is the availability of the bond proceeds not going to free up resources for something else, probably for salary or consumption expenditure increases for which the government is now seriously under pressure?

Fourth, we should be worried about the monetary and inflationary impacts.

The proceeds of the sovereign bond are likely to be deposited with the CBK prior to spending and refinancing of other debts.

This could increase the Net Foreign Assets (NFA) and consequently increase the money supply and fuel inflation.

In the event of a liquidity increase of the banking system, the CBK may be forced to mop up the excess liquidity with domestic debt instruments and consequently crowd out private investments.

Fifth, one of the reasons for the sovereign is to refinance foreign debt to reduce the cost of borrowing as well as redemption of the $600 million syndicated loan signed in May 2012 on the face of the relatively low global interest rates.

Stabilise the shilling

Whether we will really get a lower interest rate because of a sovereign bond issue is not clear, if we factor in the exchange rate variations.

The National Treasury and CBK probably hope that the sovereign bond proceeds would help to further stabilise the shilling.

The evidence from countries like Ghana that have issued sovereign bonds, however, appears to point to a different direction.

The period after its Eurobond issue, Ghana experienced heavy depreciation of its currency.

If the sovereign bond destabilizes the shilling and causes violent depreciation in its value, the National Treasury will need to mobilise more shilling resources to service these debts in the future.

The forex risk would definitely be high and a cumulative depreciation of even a small percentage on an annual basis will push up the principal repayment amount significantly.

If the government hedges this foreign currency risk, then the yields on these bonds would go even higher. It therefore remains everyone’s guess how much savings would then be realised.

It is more prudent if The National Treasury borrows from domestic markets. The focus should be on easing access to the domestic market.

Increasing liquidity and raising depth of the domestic market is the safer way to finance than to go outside and issue a sovereign bond.

There is a lot of value to be attached to Government’s borrowing in domestic markets.

We learnt those lessons during the global financial crisis. Raising more foreign debt at a time when dollar rates are set to rise is not a wise idea.

What is the point in giving foreigners a higher return when you want to deny the same to Kenyan savers?

Issuing the bonds locally and retiring a portion of the foreign debt would do wonders for the local capital market, restructure the debt portfolio, and keep the money within the country.

Indeed matters likely to arise from the sovereign bond issue are enormous.

That is precisely the reason why it is important that the National Treasury treads cautiously with its issuance and seriously weighs these matters appropriately in order to ensure that the right things are done, costly mistakes avoided and anything done is in the maximum long-term interest of the country.

The size and the nature of external debt should provide warning bells to resist the temptation of going for quick-fixes to the complex problem of our double deficits.

Borrowing money from international financial markets is a strategy with enormous downside risks, and only limited upside potential, except for the banks who will arrange it, and which would normally take their fees upfront.

Mohamed Wehliye is Senior Vice President, Financial Risk Management, Riyad Bank, KSA