Comments on Draft Decree on the Introduction of Government Bonds
COMMENTS ON THE DRAFT DECREE ON THE INTRODUCTION OF GOVERNMENT BONDS AND GOVERNMENT GUARANTEED BONDS IN THE LAO PDR Jean-Marc Lepain, Intergovernmental Fiscal AdvisorDate: August 22nd 2008 1. BackgroundIn the aftermath of the Asian financial crisis, ASEAN + 3 countries have launch the Asian BondMarkets Initiative (ABMI) to develop regional markets using common financial standards forencouraging cross border investments. Since 2003, the Lao PDR has received the financial support ofthe Japan-ASEAN Financial Technical Assistance Fund (JAFTA) in order to create a Government BoundMarket, and the ASEAN Secretariat has created the “Technical Assistance for Developing BondMarkets in Lao PDR” programme which is now in phase 2. A roadmap and work programmes havebeen developed for the creation of a bond market and the Government Joint Committee for BondMarket Development has taken the responsibility for the roadmap implementation . Nomura, aJapanese security firm, has been commissioned to prepare a draft decree for the regulation andoversight of the Lao PDR Bond Market in replacement of the old Security Law.On August 4th, the Department of Fiscal Policy of the Ministry of Finance has requested theIntergovernmental Fiscal Adviser to review on its behalf the Draft Decree on Government Bonds andGovernment Guaranteed Bonds prepared by Nomura. The Advisor has consulted with the Ministry’sTreasury Department and other stakeholders and his conclusions, reflecting a consensus in theMinistry of Finance, are presented in this memorandum. 2. Description of the decreeThe objective of the decree is to put in place a Government bond market as part of a wider effort toestablish financial markets in Lao PDR, including a Stock Market and a Security Market for corporatebonds. The decree on Government Bonds and Government guaranteed bonds will be completed by adecree on Securities Markets that call for the establishment of a Market Authority and Credit RatingAgenciesThe decree covers the following topic: the products, the role of MoF in issuing bonds, the role of BoLin organizing the sell of bonds, custodians, underwriters and investors. 2.1. Types of Government bondsThe decree covers four types of products: Treasury Bills with a maturity of less than one year,Treasury Bonds with a maturity of one year or more, Government guarantee bonds issued by Stateenterprises designated by the Prime Minister and Retail Bonds. 2.2. Currencies
Article 7 of the decree open the possibility to issue bonds not only in kips but in other currencies. 2.3. InvestorsIf we read correctly Article 8, the market will be open only to domestic investors which might include“foreign organization and individuals working and living lawfully in Lao PDR”. Accepting foreigninstitutional investors would require making the kip a convertible currency. However, there are goodreasons to exclude foreign investors as they are more likely to take a speculative approach and mightdramatically reinforce market fluctuations and increase volatility; as such is the case presently inVietnam. We advise the Ministry of Finance to review carefully the recent events in Vietnam beforemaking any decision. 2.4. Role of the Ministry of FinanceThe role of the Ministry of Finance is to define the borrowing policy of the Government, to deviseissuing strategies and to prepare quarterly programmes for issuing treasury bills and treasury bonds.Issuance of treasury bills is normally based on cash management requirements. A fine-tuned T-billpolicy will not be possible before the Treasury System is implemented. Issuance of bonds dependson the financing needs for long term investments, macro-fiscal sustainability and macro-economicstability. The MTFF and MTEF will provide the key parameters for defining and piloting the borrowingpolicy.Article 21.2 says that “The volume and interest of each of the Treasury bills shall be determinedthrough auction results”. The syntax of the sentence does not appear correct but might mean thatthe volume of T-bill effectively sold at and auction might depend on the auction result as it is thecase in the Dutch Auction system, used for example by the US Treasury. However that might not becompatible with MoF borrowing policy and it needs to be further discussed as it might influence thechoice of an auction method.MoF will establish the list of “underwriting organizations”. This will require some additionalregulation and the publication of selection criteria.In the case of Government guaranteed bonds the role of MoF is strictly limited to issuing theguarantee legal documents. However, guaranteed bond will impact the government solvability andshould be recorded as off-balance commitments. There is a risk for MoF to loose the control of itsfiscal policy if the Prime Minister Office can authorized SOEs to issue guaranteed bond withoutreferring to MoF. Within the framework of it borrowing policy, MoF might set limits for guaranteedborrowing. 2.5. Role of the Bank of Lao PDRUsual practices are that MoF give to the central bank a mandate for organising the issuance of T-billsand T-bonds either through auctions, direct sales or underwriting. The central bank, as the
Government banker, will also collect interest and capital repayments. Often this mandate isformalized by a Memorandum of Understanding signed between the MoF and the central bank.The Central Bank is also responsible for creating a Central Security Depository (CSD) which normallyis not dedicated only to Government bonds but is open to all types of securities. The central bank isthen responsible for maintaining the CSD infrastructure and issuing all the related regulation. Adedicated decree will need to be published by BoL. Additionally, MoF will need to establish theprinciples of CSD accounting. Those principles might be integrated in the BoL Decree.BoL will need to publish another decree on the eligibility criteria of candidate custodians and theprinciples of their selection.Eventually the Central Security Depository is linked to the payment system (Real Time GrossSettlement) through a Delivery versus Payment System (DvP) that ensures that the payment isabsolutely simultaneous with the security transfer and that all systemic risks are eliminated. 2.6. Custodians and underwritersThe decree does not make a clear distinction between custodians and underwriters as custodians arealso expected to act as underwriters. A custodian is a financial institution that has received theagreement of the central bank to hold and manage bonds recorded in the Central SecurityDepository on behalf of its customers. This suggests that custodians might become active inorganizing a secondary market, either in organizing bond transactions between their customers orselling bonds to each others. 3. Assessment of the decreeThe technical content of the decree is excellent and reflect the expertise of Nomura. However, thedecree in the present stage remains high level and does not provide the sort of details required for abond market to become operational. The decree calls for (a) secondary regulation that will defineprocesses and procedures, (b) a clarification of the Government borrowing policy, (c) a feasibilitystudy.As such the decree is not complete enough to allow a market to start operating. Not only it requiresas expected additional regulation, but a better definition of instruments and of participantresponsibilities must be introduced in the law. The scheduled feasibility study is expected to solvethese problems.Secondary legislation could take the form of a circular issued by MoF or the Prime Minister Officeand a circular issued by BoL. Those circulars will give more information on the financial instrumentssuch as maturities, calculation of interest, secondary markets, method of auction, role of theunderwriters, conditions under which an investor can activate the Government guarantee,accounting rules, custodian risk management rules and internal control, custodian insurance, etc.
In the absence of a State Borrowing Policy Paper, it is difficult to assess the decree. A BorrowingPolicy does not reflect only fiscal policy considerations but also monetary policy considerations thatmust be discussed with BoL. The Government must first define the objectives of its borrowing policyand then devise a strategy to meet those objectives. When such a strategy will be ready, it willbecome possible to see if the decree and the secondary regulation allow meeting the objectivesthrough the approved strategy. In practice, drafting of the regulation will be impossible in theabsence of such a policy paper.The decree does not say anything on market makers and by what mechanism the transaction price ofa bond will be established on the secondary market. 4. Borrowing PolicyIt will not be possible to prepare the regulation required by the decree unless a Borrowing Policy isput in place. The Borrowing Policy is currently under preparation by the External FinanceDepartment, but we have not had access to its preliminary findings and therefore are not in positionto make any recommendation.The debt sustainability analysis conducted in 2007 indicates that the Lao DPR continues to face a highrisk of debt distress although all indicators at that time were positively oriented and debt serviceratio remaining relatively low. While nominal debt stocks have increase, strong growth has led thenominal debt-to-GDP ratio to steadily decline since 2002. Since 2006 all debt service indicators havereversed their upward trends, reflecting continued strong GDP and export growth. However the sizeof the domestic public debt is negligible. This situation opens the possibility to substitute domesticdebt to international borrowing, although 75% of the country external public debt are highlyconcessional loans.Presently all domestic debt is made of short term T-bills. It pertains to the Borrowing Strategy todecide if there is an opportunity to substitute long term bonds to short term T-bills, knowing thatsuch a policy can become effective only when the Cash Management System is implemented. TheBudget Law does not allow borrowing for financing recurring expenditures. However, from a cashmanagement viewpoint, when a treasury gap occurs, it is impossible to separate recurringexpenditures from investments. The usual policy is to use T-bills for short term gap resulting fromdelay in revenue collection, and long term bonds for structural needs. If the analysis shows that thereis a minimum revolving stock of T-bills that represent a structural long term deficit, it is possible toconsider substituting long term bonds.The question of substituting bonds to T-bills must be decided by an analysis of the opportunity cost.Long term bonds represent for the Treasury a steady source of financing that reduces the interestrisk, especially within the context of raising inflation and interest rates. On the other hand, the costof borrowing long term is usually higher than the cost of borrowing short term. However, in Lao PDRthe market of interest rate instruments is not developed enough to make prediction on the yieldcurve.Another risk to be taken in consideration is the risk of depreciation of the Government bonds ifinterest rates rise sharply (see Vietnam in section 6) and the risk that investors loose confidence in
the market, forcing the Government to borrow at higher rates. Many techniques exist for mitigatingthis risk. Accounting rules play an important role. If insurance companies are obliged to mark tomarket the value of their portfolio even if they intend to keep the bond until their maturation theymight be reluctant to buy the bonds or will ask for a risk premium. Central Bank policy plays also animportant role for the bank. Open market policy, pension and repurchase agreements might help increating some market liquidity.The development of a Government bond market is far less risky than in international currencies. TheDecree opens the possibility of issuing bonds in foreign currency and this question should be decidedby the Borrowing Policy paper as it involves certain risks.The borrowing policy should be formalized in a borrowing policy paper to be integrated in a FiscalPolicy Declaration which is usually one of the preliminary budget formulation document presented tothe Cabinet and the Parliament. 5. Potential impact on the macro-economic and fiscal outlookAccording to the IMF, “Public domestic debt in low-income country and emerging markets remains acontroversial issue…” (IMF Working Paper 07/127). An analysis of pros and cons leaves a very miximage. Issuing domestic debt, whether to finance the fiscal deficit or to mop up liquidity, involves acomplex evaluation of the costs and benefits to the economy.Traditional public finance literature highlights the risk of encouraging the issuing of domestic publicdebt and its potential negative impact on private investment, fiscal sustainability, growth andpoverty reduction: The most prominent concern is the crowding out effect on private investment. Bank might find investing in Government bonds an attractive low risk substitute to financing the economy through commercial loans. This attitude might have in the long term a negative impact on growth. Domestic borrowing is more expensive than concessionary borrowing. ADB and World Bank Treasury Loans can be excellent substitute to domestic borrowing for financing structural needs if the loan conditionality is accepted. With domestic borrowing, the final cost of borrowing is unknown and might rise sharply due to rising interest rate and time inconsistency when Government credibility is low. Stimulation of financial markets can contribute to economic growth in a way that beneficiates only the affluent part of society but create a type of economy with more exclusion for the poor.However, in the recent years more voices have increasingly echo the positive view of many marketparticipants regarding the importance of domestic debt instruments for monetary, financial and fiscalsystems. The proponents of domestic debt stress its positive impact on growth, inflation and savingsas well as the contribution that more sophisticated financial markets can make to economicdevelopment.
Here are some of the main advantages that they identify: The development of a Government bond market is an important stimulant to the development of a security markets in the absence of potential private borrower. It will help the Central Bank to set interest rates for different maturities and be used by commercial banks as a pricing benchmark. Government bonds are an important instrument for the conduct of indirect monetary policy operation and collateralized lending in inter-bank markets, reducing the need for frequent central bank intervention. Domestic debt markets might stimulate population saving, having a positive effect on inflation and on macro-economic stability. The example of China and India are often given, but they are very large economies. International borrowing, even at concessionary rates, exposes the country to exchange rate risk (although with a weak dollar the risk seams mitigated). Domestic debt reduces the vulnerability to international market shocks. Budgets finance sectors such as agriculture, sanitation, public work which are unattractive to the banks. Government bonds mobilize bank deposits and redirect national saving to the financing of those sectors.Coming to a clear cut conclusion in this debate is difficult. A complete review of these factors is notpossible in the framework of such a short note. Those questions need to de debated and clarified inan in depth discussion of borrowing policy. 6. The example of VietnamVietnam offers a good example of the damage that a poor borrowing policy can make. It is estimatedthat by July 2008 Vietnam has issued more than US$ 15 billions of Government bonds, of which US$3 billions are hold by foreign investors. With raising inflation, the Bank of Vietnam has been obligedto raise significantly its rates. As a result Government bonds have lost 30% of their value and themarket confidence in Government has been greatly damaged. The depreciation has been aggravatedby foreign investors who have closed their positions and left the market. As a consequence if theGovernment wants to mobilise capital at this moment, it has to pay a risk premium that put the bondyield above inter-bank rates. 7. Feasibility StudyThe implementation of a Government bond market will take many years and should be seen with thecontext of the Government priorities. Although it is always possible to develop a legislativeframework to leave all options open, a bond market will also require a heavy investment in ITinfrastructure. For MoF, the priority should be the implementation of the Treasury System includingthe cash management module, the implementation of a debt management system and the
implementation of the Treasury Single account. For BoL the priorities should be the implementationof its General Ledger, the implementation of the account management system and theimplementation of its payment systems. Only when whose systems are in place, will it be possible toconsider a Central Security Depository and a Delivery versus Payment system. Therefore we areconsidering a time horizon which is 4-5 years minimum. This gives already an indication that there isno reason to speed up the development of security markets.The delayed in BOL for implementing an information system covering banking operations, accountmanagement and general ledger on one hand, and a real time gross settlement system on the otherhand, might become a serious bottleneck of the development of bond markets. It is important thaton this issue MOF and BOL coordinate their policy.A feasibility study should take into consideration all those aspects. It is understood that the ASEANSecretariat is already preparing the Terms of Reference (ToR) of the next phase projects. Those ToRinclude a feasibility study for issuing long-term bonds. This feasibility study will focus on three points: Whether the economy is stable enough to issue long-term government bonds, including estimation of the possible size of the issuance; Identification of potential investors for long term government bonds; Suitable terms and conditions (i-e terms, interest rate, form, etc.) of Government long-term bonds.It should be noticed that the ToR do not include a feasibility study for the infrastructure and does notseem to consider the prioritization of reforms within the Government. 8. Conclusions A good borrowing policy should be neutral in terms of size of the budget and budget deficit. The introduction of a Government bond market may have a significant impact on the monetary and fiscal policy of the country and affect its macro-economic stability. The issuance of domestic debt has a combination of positive and negative effect on the economy. There is no evident conclusion in the case of Lao PDR. The same causes produces different effects in different countries, depending on the size of the economy, the culture of people, their saving habits, attitude toward financial risks, experience with inflation, etc. The development of a long term bond market implies some serious risks that must be carefully analysed. The Draft decree on Government Bonds and Government Guaranteed Bonds raise a number of issues that can only be clarified within the framework of a borrowing policy study including a debt sustainability analysis and a modelling of different scenarios. The Draft decree remains incomplete and will require for its implementation extensive regulation that might require several decrees or circulars from the Prime Minister Office, the
Ministry of Finance and the Bank of Lao PDR. Without an approved Borrowing Policy Paper it will be impossible to start drafting the regulation. The Feasibility Study scheduled by the ASEAN Secretariat will also be dependant for progress on the Borrowing Policy Paper. In addition to the three points mentioned, the study should also address the issue of the technical infrastructures required. It should include a tentative date for starting the implementation of the Central Security Depository and an overall cost estimate of the whole projects. It also needs to address the issue of the prioritization of the different infrastructure projects inside MoF and BoL.