Derrill allatt sovereign debt


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Evaluating Sovereign Risk: Debt and Capital Markets. Derrill Allatt, Managing Partner, NewstatePartners, LLP
The panel will address the current state of sovereign capital markets, the realities of issuing government debt, and the future state of financing government expenditure.

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Derrill allatt sovereign debt

  1. 1. Current Perspectives on Sovereign Debt<br />2010 ICGFM Miami Conference <br />
  2. 2. Key Challenges Facing Debt Management<br />2<br />Part 1<br />
  3. 3. Determining Sustainable Level of Debt<br />Several debt measures are utilised by debt managers and international investors to evaluate the sustainability of debt in a given country<br />Debt-to-GDP<br />The public-sector-debt-ratio provides the clearest picture of a country’s public sector debt stock as a percentage of annual production. Generally a level over 60% is considered high. Those countries with higher credit worthiness are able to borrow more without affecting their sovereign ratings as can be seen by the parabolic relationship between Debt-to-GDP and credit rating <br />Interest-to-Revenues<br />The ratio of public sector interest-to-general government revenues is the most commonly used measure of interest affordability as it provides an indication of the interest burden on annual fiscal resources. One government may have a high level of debt, however, through heavy concessional borrowing, might face a lower level of interest than another government with a lowerlevel of debt<br />A ratio above 15% of revenues is generally considered high<br />External Short-Term Debt-to-Reserves<br />A metric of short-term external financing constraints, this ratio describes short-term debt (current-year amortisations, money market instruments, currency and deposits) as a percentage of central bank international reserves<br />2009 Public Sector Debt-to-GDP vs.. Credit Rating<br />Interest-to-Revenues vs.. Credit Ratings<br />Part 1: Key Challenges Facing Debt Managers<br />Jamaica<br />Greece<br />Iceland<br />Israel<br />Philippines<br />Ghana<br />Bolivia<br />Russia<br />Chile<br /> AAA AA A BBB BB B CCC<br />Jamaica<br />Source: IIMF; S&P, Moodys; Fitch<br />Pakistan<br />Costa Rica<br />Iceland<br />Israel<br />Bolivia<br /> AAA AA A BBB BB B CCC<br />3<br />
  4. 4. Credit Ratings and Debt Sustainability<br />S&P, Moody’s and Fitch all factor debt sustainability into their determination of credit ratings. These ratings then affect a Government’s ability to borrow externally. Additionally, ratings may serve as country ceilings, which affect the borrowing cost of private enterprises operating within a rated country<br />The level of a country’s indebtedness is a major factor affecting its credit rating. While countries with historically strong sovereign credit worthiness, like Japan and Spain, may be given more flexibility in sustaining more debt, emerging market nations have traditionally been perceived as riskier.<br />Recent events have called into question the debt sustainability of those historically AA- and AAA-rated nations like Greece, Spain and Portugal, which have faced downgrades in recent months<br />IFR; Bloomberg, all figures as of 04 May 2010<br />Aggregated Sovereign Credit Rating vs.. Borrowing Spread<br />Pakistan, 651bps<br />Greece, 643 bps<br />Ukraine, 551 bps<br />Iceland, 375 bps<br />Portugal, 275 bps<br />Romania, 233 bps<br />Philippines, 168 bps<br /> AA A BBB BB B CCC<br />Part 1: Key Challenges Facing Debt Managers<br />4<br />
  5. 5. Managing Rollover Risk<br />Many governments worldwide (particularly within Europe) face large rollover requirements as a percentage of GDP in 2010before any allowance for financing budgetary deficits<br />Debt rollover ratios exceed 20% of GDP for Belgium and Italy. <br />Spain, for instance, must issue EUR 225bn this year in order to rollover its outstanding debts falling due in 2010, even though Spain has a debt-to-GDP of only 54% compared with 125% for Greece and 76% for Portugal.<br />In addition to the need to refinance maturing debt, many European and other governments will need to increase their borrowings to finance their budgetary deficits.<br />S&P has projected that European governments will be forced to borrow a record €1,446b in 2010 due to deteriorating public finances. <br />IMF, S&P<br />Advanced European Market Debt-Rollover Ratios<br />EMEA Debt-Rollover Ratios<br />Part 1: Key Challenges Facing Debt Managers<br />5<br />
  6. 6. Rising Fiscal and Balance of Payments Deficits<br />Many governments face mounting fiscal and external financing deficits as a result of the global economic turbulence. <br />Fiscal Deficits<br />Many governments are facing soaring fiscal deficits caused by poor fundamentals and crisis-related response measures:<br /><ul><li>Falling tax revenues as a result of lower real incomes, higher unemployment and decreased consumer spending
  7. 7. Decreased customs duties caused by a decline in global trade
  8. 8. Higher than anticipated expenditures caused by financial crisis response measures such as bank takeovers and deposit guarantees
  9. 9. Fiscal stimulus measures required to meet social needs and combat recessionary unemployment</li></ul>Balance of Payments (External financing deficits)<br />Many countries face severe balance of payment shortfalls that have forced Governments to deplete reserves, devalue the national currency or resort to IMF lending:<br /><ul><li>Economic weakness in historic trading partners has cut currency inflows and led to a shortfall in foreign exchange
  10. 10. Some governments are borrowing abroad in order to guarantee that they have adequate forex for their central banks
  11. 11. The inability to service or rollover large foreign-denominated debt payments (public sector or otherwise)
  12. 12. Those Governments situated in currency unions may face additional pressure due the inflexibility of monetary controls and the inability to devalue</li></ul>Twin Deficits<br /><ul><li>Some countries face combined fiscal and current account deficits, such as Spain and Iceland, which require external financing</li></ul>Part 1: Key Challenges Facing Debt Managers<br />6<br />
  13. 13. Contagion<br />Contagion describes the phenomena whereby financial shocks are transmitted from one economy to other interdependent economies. The term came into wide use during the late 1990s when financial crises spread across emerging market economies, affecting nations with healthy fundamentals and sound fiscal, monetary and exchange rate policies<br />Various theories exist to explain why contagion occurs including: real links such as trade, the pass through of higher/lower market interest rates, a herd mentality among investors, and operations of multinational financial institutions spreading economic distress and investors selling debt of one country to fund losses elsewhere in the portfolio<br />The threat of contagion is very real to debt managers as exogenous events can lead to the transmission of higher interest rates, reduced financing options and speculative exchange rate attacks that undermine the external balance and cause any number of other economic distress factors<br />Bloomberg<br />CDS Lockstep Movements Among Emerging Market Peers<br />Part 1: Key Challenges Facing Debt Managers<br />7<br />
  14. 14. Reaching Investment Grade<br />IFR May 8 2010, Moody’s, S&P, Fitch<br />Why are some emerging market countries perceived as less risky than their peers?<br />Part 1: Key Challenges Facing Debt Managers<br />8<br />
  15. 15. Reaching Investment Grade<br />Over the past decade, a handful of emerging market governments have ‘beaten the odds’ to achieve the necessary fiscal , debt and external sustainability associated with investment-grade sovereign credit ratings. There are a number of discernable trends among those countries that have risen several notches despite global adversity:<br /><ul><li>Structural reforms to achieve economic-financial stability (Botswana)
  16. 16. Decreasing dependence on commodity exports (Kazakhstan, Trinidad & Tobago)
  17. 17. Taking advantage of higher growth to improve fiscal position and to reduce debt (Russia)
  18. 18. Implementation of Investor Relations Programmes (IRPs) (Brazil) </li></ul>Because of the recent turmoil surrounding the European sovereign debt crisis, a number of emerging market countries are now being perceived as less risky than advanced country peers. For instance, Chile’s CDS has recently been trading below UK’s. CDS for Brazilian, Mexican and Polish bonds are trading below those of Portugal<br />9<br />Part 1: Key Challenges Facing Debt Managers<br />.<br />Source: S&P<br />S&Ps sovereign ratings methodology categories<br />
  19. 19. Part 2<br />Some Solutions and Strategies<br />10<br />
  20. 20. Sources of Funding<br />Bilateral and multilateral borrowing increased dramatically in the sovereign borrowing mix in 2008 and through much of 2009 due to reduced availability of external commercial financing<br />Many Governments have sought IMF assistance in the form of a stand-by-arrangement (SBA) or drawn on the IMF’s Flexible Credit Line<br />Some sovereigns with SBAs and FCLs have already returned to the international capital markets - even before the availability of official sector funding ends as was the case of Hungary in July 2009 and January 2010<br />Part 2: Some Solutions and Strategies<br />IMF<br />Current IMF Programmes (as of 29 April 2010)<br />11<br />
  21. 21. An Effective External Debt Issuance Strategy<br />With US interest rates at historic lows, widespread tightening of credit spreads from crisis levels, and increased demand for sovereign bonds, many Governments have turned to the capital markets in recent months. Eurobond issuance provides access to external financing at market rates and can have knock-on benefits for the sovereign issuer<br />Eurobond issuance is a key source of financing for governments. If conducted prudently, Eurobonds can have beneficial ‘benchmarking’ effects on a country’s finances and provide a variety of benefits:<br /><ul><li>Creating a benchmark for the external cost of borrowing for private sector enterprises
  22. 22. Extending the country’s yield curve
  23. 23. Encouraging greater investor interest (‘placing the country on the map’) in other sectors</li></ul>During 2009, sovereigns out-issued corporates US$129b to US$115b, with the bulk of issuance coming in the second half of the year. Sovereign bond issuance is already up by more than two-thirds in the first quarter of 2010<br />Thompson Reuters, Development Prospects Group<br />Part 2: Some Solutions and Strategies<br />12<br />
  24. 24. Appointing Lead Managers<br />For a major international issue by a sovereign, there is typically a single lead manager or “bookrunner” or two lead managers (joint bookrunners), who take responsibility for the transaction. They will have an active participation in the transaction including distribution and most importantly from the investors’ perspective, providing a continuing secondary market throughout the life of the issue<br />The main problem faced by new or infrequent issuers is ensuring that the issuer retains control throughout the issuance process. It is important to remember that lead arrangers have two sets of clients, investors as well as the issuer. Only by remaining active in the process, can the sovereign issuer ensure that its interests are being placed ahead of those of the lead manager’s investors<br />Key Criteria for Appointment of a Lead Manager(s) for International Bond Issue<br />The appointment of the bookrunning manager(s) is a key decision in approaching the international bond market. To ensure maximum transparency in the process, an issuer should arrange a “beauty contest” for the award of the mandate<br />As there will be a period of up to three months between awarding the mandate on the one hand and the pricing and launch of the transaction on the other, the mandate for the issue should not be awarded solely on the basis of price as market conditions may change substantially in the intervening period<br />The most important criteria for the appointment of the lead manager for an international bond issue include:<br /><ul><li>Knowledge of and commitment to the particular government
  25. 25. The quality of economic and sovereign credit research and, most importantly, understanding of the country, its economic and political conditions and its creditworthiness
  26. 26. Experience in lead managing similar sovereign issues, including for example experience in bringing sub-investment grade sovereign borrowers to market
  27. 27. Distribution capability and willingness to support the transaction in the aftermarket
  28. 28. Individual character of the team assigned to the transaction; level of senior resources to be allocated, degree of familiarity with the country</li></ul>Part 2: Some Solutions and Strategies<br />13<br />
  29. 29. Case Study: Russian Federation<br />Situation Overview<br />After recovering from its debt crisis in 1998, the Russian economy sustained ten years of economic growth in excess of 5% through 2008. Oil receipts enabled the Russian authorities to accumulate assets in their National Wealth Fund and Fiscal Reserve Fund, which stood at US$88.8bn and US$40.9bn respectively as of 1 May 2010. These assets were instrumental in propping up the Russian private sector when the global financial crisis caused the Russian economy to contract by 7.9% GDP in 2009. No Russian credits suffered international bond defaults, in part due to well-timed interventions by the Russian authorities<br />Prior to the most recent issues, Russia hadn’t issued in the international capital markets for many years, and its return required the development and implementation of a detailed medium-term external funding strategy that began in mid-2009 in order to obtain the lowest pricing possible<br />Issuance Strategy<br />The Russian Federation returned to the capital markets in order to provide corporate and sovereign-related entities with new sovereign benchmarks that would enable them to tighten their own credit spreads. Russia sought to raise US$5.5bn from five and 10-year issuances<br />The Russian authorities took a hard-line on the pricing of the new bonds. Issuance at the tightest possible spreads was prioritised over achieving a high oversubscription ratio. The book size was deliberately kept under wraps in order to prevent investors from inflating orders<br />Outcome<br />Russia’s five- and ten-year issues were priced in line with official guidance at 125bps and 135bps wide of US Treasuries respectively and the bonds were two times oversubscribed, even in the face of a weak market. The ten-year yield fell inside of the Italian and Spanish sovereign yield curves. The issuance achieved the Ministry’s objectives of repricing the sovereign curve and establishing benchmarks for future supply<br />Russia MoF<br />Part 2: Some Solutions and Strategies<br />14<br />
  30. 30. ‘Domestic Eurobonds’<br />While a ‘Eurobond’ is a bond governed by a foreign law to foreign investors and issued in foreign currency, some governments have sought to issue bonds governed by a foreign law to foreign investors but denominated in their domestic currency as a means of widening their investor base. This would provide an issuing government with several benefits:<br /><ul><li>Domestic bonds are placed on western clearing systems making them available to investors worldwide
  31. 31. Issuances could be simultaneously placed on domestic and foreign markets allowing for the widest possible investor base
  32. 32. Domestic issuance develops the domestic local-currency debt markets
  33. 33. Widely available local-currency bonds could pave the way for foreign investors to increasingly invest on local-currency exchanges and in private sector corporates
  34. 34. Local-currency bonds help governments insulate debt obligations from the risk of large fluctuations in global exchange rates</li></ul>There are also a number of risks associated with local-currency external issuance:<br /><ul><li>Risk of contagion from the global financial markets into the local-currency markets
  35. 35. Domestic-currency bonds could be ‘dumped’ rapidly by global investors causing more volatile price movements. More sophisticated investors may be located abroad, leaving domestic holders to bear the brunt of any depreciation in government debt assets
  36. 36. In order to have a successful local-currency issuance, capital controls must be limited or scaled back, which is a concern in some economies
  37. 37. External issuance of a domestic instrument is more expensive as legal costs, clearing mechanisms, road-shows and investor relations take on global proportions</li></ul>Part 2: Some Solutions and Strategies<br />15<br />
  38. 38. Investor Relations Programme (IRP)<br />Investor Relations Programmes help Governments develop debt issuance programmes and ensure awareness among the emerging market investor base. They do not serve as a substitute for sound policies. <br />The main benefit of an IRP to a Government is in crisis prevention and resolution. It provides an appropriate institutional framework to convey information on macroeconomic policy objectives, economic performance and policy implementation<br />An IRP facilitates constructive dialogue between authorities and investors and enhances the decision making process through the provision of timely information<br />A well formulated Investor Relations Programme:<br /><ul><li>Helps shape investor perceptions of the economy
  39. 39. Provides a channel for interacting with market participants and investors
  40. 40. Helps judge the potential timing of issuance in global capital markets, especially in instances of prolonged absences from the markets
  41. 41. Contributes to a more positive perception of the country by investors when making decisions to either maintain or increase exposure to the country, even in the face of increasing external payments pressures
  42. 42. Increases transparency and engenders credibility and good faith
  43. 43. Helps promote the development of domestic capital markets
  44. 44. Helps reduce vulnerability to adverse shifts in market sentiment, whether caused by country-specific concerns or by market-induced contagion
  45. 45. Corrects inaccurate information and dispels rumours
  46. 46. Helps monitor capital flows into the country</li></ul>Part 2: Some Solutions and Strategies<br />16<br />
  47. 47. Investor Relations Programme (IRP) (cont)<br />A country’s sovereign debt is one of a large number of competing investment opportunities. Investors expect authorities to provide and support the same level of access to information as corporates are required to provide. Authorities are expected to provide data in a timely manner – to help creditors better assess risks<br />Creditors and Investors expect an Investor Relations Programme to:<br /><ul><li>Be a reliable, objective and timely source of information
  48. 48. Disseminate concise data on macroeconomic and financial policies, as well as information about structural issues
  49. 49. Provide a direct channel of communication with government officials and decision-makers
  50. 50. Provide clarification and financial updates as necessary
  51. 51. Provide detailed information on the sovereign’s macroeconomic position, updated forecasts and insight on financing plans and other forthcoming events
  52. 52. Provide forward looking information on medium-term macroeconomic objectives and proposed policy measures, including future financing needs, debt position, amortisation schedules, future debt issuance, etc</li></ul>An IRP needs to create formal communication channels for two-way exchange of views and information between sovereign debtors and market participants <br />Part 2: Some Solutions and Strategies<br />17<br />
  53. 53. Investor Relations Programme (IRP) (cont)<br />Many sovereigns have been rewarded for the transparency of their investor relations efforts during the implementation of policy reforms. In the cases of Brazil, Turkey, and South Korea, for instance, the proper conveyance of their reform agenda through well established IRPs helped reduce borrowing costs. As can be seen below, the introduction of an IRP lowered the USD yield curve at 5-years by an average of 164bps for the sampled countries <br />Sovereigns with developed programmes have fared better than those without. There is correlation between the rating of a country’s programme and its ability to withstand external shocks<br />As can be seen below, those countries having the higher rated IRPs had lower 5-Year CDS spreads. This is indicative of the benefit of an open and transparent relationship between the sovereign issuer and investors<br />Effect of IRP on Spread to USD Swaps <br />‘09 IIF Weighted Score vs.. CDS Spread (13 May 2010)<br />Venezuela<br />Pakistan<br />Ukraine<br />Institute for International Finance, Bloomberg<br />Dom. Republic<br />Part 2: Some Solutions and Strategies<br />Philippines<br />Turkey<br />Brazil<br />Peru<br />18<br />
  54. 54. Domestic vs.. External Borrowing<br />Domestic vs.. external debt financing should aim at minimising cost and risks for the overall economy<br />There is no optimal approach for all circumstances as it depends on the availability of financing, economic environment, institutional framework and the degree of development of the domestic financial markets. However, there are a handful of factors that should be reviewed when deciding whether to borrow domestically or externally:<br />Part 2: Some Solutions and Strategies<br />19<br />
  55. 55. Debt Reprofiling<br />Debt reprofiling describes the process whereby a government consults with creditors to adjust the maturity or coupon structure of outstanding debt obligations in order to better meet the government’s external or fiscal payment calendar. Often, this is done through the creation of a new instrument or instruments, which are then exchanged for the old instrument<br />Important Considerations<br /><ul><li>Investors generally accept a profiling mechanism that solves a Government’s short-term liquidity problem
  56. 56. The preventative approach is suitable in those countries, which are able to anticipate and publicly acknowledge the existence of a liquidity problem before it becomes a solvency problem
  57. 57. In outright solvency crises, voluntary debt exchanges are more difficult to achieve
  58. 58. A candid dialogue is essential in order to gauge creditor tolerance for an NPV reduction, obtain feedback on how to improve a proposal and generate an atmosphere of trust
  59. 59. In any voluntary debt exchange, free-riding holdout creditors are a problem. A number of legal mechanisms including the Collective Action Clauses (CAC) and Exit Consents exist to address the holdout problem</li></ul>Phases<br /><ul><li>Diagnostic Phase (Evaluate debt management alternatives)
  60. 60. Identify Creditors
  61. 61. Build the case for debt relief
  62. 62. Consultation Process
  63. 63. Exchange Offer
  64. 64. Bring in remaining investors</li></ul>Part 2: Some Solutions and Strategies<br />20<br />
  65. 65. Case Study: Belize<br />Situation Overview<br />Belize’s public sector debt stock rose rapidly from 2000 to 2005, driven by increased borrowing from private sector sources in order to finance the cost of emergency relief and the reconstruction process following a series of natural disasters in the period from 1998-2002. Repeated refinancing operations in previous years led to a consistent rise in borrowing costs: the effective weighted average interest rate on the external commercial debt stood at approximately 11.25% in mid-2006 <br />In mid-2006, Belize’s public debt burden stood at approximately US$1.1b, which was equal to over 90% of estimated GDP. Interest on the public debt was due to exceed 27% of fiscal revenue in 2006. Servicing the external debt absorbed an average of 46% of Belize’s annual foreign currency earnings from exports of goods and services since 2002. Furthermore, debt service due to external commercial creditors was characterised by spikes caused by bullet maturities, some of which were linked to put options held by creditors <br />Macroeconomic projections, undertaken in conjunction with the IMF, showed that Belize’s debt burden would contribute to acute twin financing shortfalls in the short- to medium-term<br />IMF, Belize MoF<br />Debt Stock Before Restructuring (June 2006)<br />Savings Generated by Debt Exchange Offer<br />Part 2: Some Solutions and Strategies<br />21<br />
  66. 66. Case Study: Belize (cont)<br />Exchange Strategy<br />Belize pursued a strategy based on:<br />The full and early engagement of creditors through open and constructive dialogue <br />A policy of transparency in the dissemination of all economic and financial data and assumptions <br />A willingness to find a solution that would address Belize’s needs in a credible manner but that would also be perceived as fair by creditors <br />The support of the IMF, the IADB, and the CDB <br />Before entering into dialogue with creditors, Belize built a case for debt relief by producing detailed macroeconomic projections that took into account the impact of the authorities’ economic reforms and the financial assistance expected from multilateral and bilateral lenders. The authorities presented creditors with a number of indicative debt restructuring scenarios, all comparable in NPV terms<br />In December 2006, Belize announced the broad terms of its exchange offer and simultaneously suspended interim debt service payments. In order to ensure comparable treatment in NPV terms for all participating creditors, Belize incorporated exchange ratios into the exchange offer. Special legal procedures were put in place to encourage the reconstitution of stripped instruments as well as the use by participating creditors of the collective action clauses (CACs) embedded in some of the affected instruments <br />Outcome<br />Holders of 96.8% of the affected debt tendered their claims. The new debt service profile for the external commercial debt was radically different from the original one. Between 2007 and 2015, Belize will benefit from cash flow savings equal to US$482m. Additionally, consolidation of the country’s external commercial debt into a single benchmark-size (US$547m) instrument encouraged trading in Belizean instruments and broadened the country’s investor base<br />A major economic crisis was averted and Belize now has a debt burden that has proven sustainable. The country’s credibility and standing in the international financial community was preserved: creditors acknowledged that Belize conducted itself in a transparent and responsible manner in very challenging circumstances <br /> <br />IMF<br />Part 2: Some Solutions and Strategies<br />22<br />
  67. 67. Discussion: Greece <br />Greece faces what is arguably the most significant financial crisis in an advanced economy in recent memory. There are a number of pertinent issues, which the Greek authorities must now face: <br /><ul><li>Assuming Greece draws fully on US$145bn of bailout funds to cover maturing debt obligations and finance its budgetary deficits, there is still the question of whether or not the Government will be able to resume borrowing at lower rates of interest
  68. 68. Will the markets be successfully persuaded that Greece can achieve debt sustainability without a comprehensive or partial debt restructuring?
  69. 69. If a restructuring of Greece’s debt becomes inevitable, will the Government have missed out on an opportunity to take a decisive and pre-emptive debt reprofiling action while it still had funds at its disposal?</li></ul>Part 2: Some Solutions and Strategies<br />23<br />
  70. 70. Contact Us<br />For further information, please contact:<br />Derrill Allatt<br />Managing Partner<br />Newstate Partners LLP<br />33 Cavendish Square<br />London W1G 0PW<br />Phone: +44 (0) 20 7182 4641<br />E-mail:<br />Website:<br />24<br />