Pakistan Returns – Dr Ashfaque H Khan

Pakistan has made a successful return to the international bond market for the first time in over seven years. Initially targeting to raise $500 million, Pakistan raised the transaction size to $2 billion at the back of the strong demand of its paper by high quality and diversified international investors resulting in multiple time over-subscription. Pakistan has sold a $2 billion dual tranche note on April 9, 2014, divided into five and ten year tranches of equal size ($1 billion each).

This transaction is Pakistan’s largest international sovereign bond offering to date and attracted significant interest from global investors, especially from the US. Pakistan’s 5 and 10 year bonds’ yields are 7.25 percent and 8.25 percent respectively which are priced at 558 basis points (bps) and 556 bps above the corresponding benchmark rates of US Treasury 5 and 10 year, respectively.

Why do countries go to the international bond market? There are two types of countries that launch their sovereign bonds. The first type includes countries desperate to raise fund to meet debt payment obligations or build their foreign exchange reserves to provide stability to their exchange rates. Such set of countries do not hesitate to offer high yield on their papers in act of desperation. For yield-hungry global investors, such set of countries is considered earning paradise.

The second type of countries is those who are not interested in money, rather they want to showcase their growing economic strength to global investors. They are frequent issuers of bonds with the sole purpose of remaining in touch with markets and investors. For example China, with over $3.5 trillion reserves, is a frequent issuer of sovereign bonds in order to showcase its improving credit fundamentals to the rest of the world.

There could not be a better time for Pakistan to go to the international bond markets. The global market is flooded with liquidity as a result of continued Quantitative Easing policy pursued by the United States. Even today, the Federal Reserve is pumping $75 billion per month to revive US economy. As a result, the interest rates are at an all-time low and global investors are anxiously looking for high yield bonds to park their otherwise cheap money. Therefore, Pakistan chose the best time to go to the market to raise funds.

It was indeed courageous on the part of the government to undertake 144A/Reg S transaction which enabled it to hold a road show in the US market. Pakistan’s current credit rating is below seven notches of the investment grade (caa1) by Moody’s and six notches below (B-) by Standard & Poor’s. Such a poorly rated country seldom takes risk in entering the US market for a road show. But Pakistan went to the US market, attracted enormous demand for its paper and accordingly offered more than half to the US investors. This is indeed a great success for the finance minister.

There are three stakeholders of this transaction – the government, the global investors and the lead managers (Barclays, Citigroup, Deutsche Bank and Merrill Lynch). While all the stakeholders are winners and beneficiaries of this transaction, the only loser is perhaps the country. By looking at the size of the transaction, Pakistan gave the impression of being a desperate borrower to the global investors. Initially targeting to raise $500 million, when Pakistan saw such an overwhelming response from global investors, it raised the size of the transaction by four times ($2 billion).

Pakistan needed dollars badly to meet the end June gross international reserves target of the IMF programme. Therefore, it did not even bother to pay such a high spread over the benchmark US treasury rates. With this transaction, Pakistan has set its new benchmark for five and ten year papers with spread of 556 bps and 558 bps, respectively. The last bond the country floated in May 2007, amounting $750 million for a ten-year maturity, attracted a spread of 200 bps.

The new pricing benchmark is certainly expensive and will have a far-reaching adverse impact on privatisation in determining the benchmark price for the item to be privatised, GDRs (Global Depository Receipts) and for borrowing by the private sector in international markets.

Given Pakistan’s current debt profile, borrowing such a heavy amount at a relatively high cost in the midst of payment to previous and current borrowing from the IMF, short-term borrowing from the Islamic Development Bank, Standard Chartered Bank-led consortium of commercial banks and repayment of the thus far rescheduled Paris Club loan starting 2016, will cause serious debt servicing difficulties. The new borrowing ($2 billion) will entail interest payment of $155 million per annum in the next five years and $82.5 million per annum in the remaining five years.

If I were in the Ministry of Finance, I would have advised the finance minister not to take more than $500 million and tighten the spread, work with rating agencies to improve rating, return to the market at the back of a grand success in the next three months, further tighten the spread and continue to build upon the success. Perhaps, during the next one or two years Pakistan’s spread would have come down to 350-400 bps and to 200-250 bps in the next three to four years.

The second stakeholder is the global investors. Inundated with liquidity, the yield-hungry global investors looking for a high yield bond responded overwhelmingly to Pakistan’s paper, offered between $5 billion and $7 billion and finally parked $2 billion-$1 billion each at 7.25 percent and 8.25 percent. There cannot be a better investment than parking liquidity with Pakistan at such wonderful rates.

The third beneficiary/winner is our lead managers. While they have done an excellent job in building the size of the book, inviting quality investors across all regions and making the road show a grand success, they should have advised the minister to not take more than $500 million as initially envisaged. I assume they did not advise the minister accordingly. Nevertheless, they earned their fee four times more than what they could have earned with $500 million transaction. Not a bad deal either for the bankers.

Finally, a word of caution. There are views emerging in the print media that now that Pakistan has built significant foreign exchange reserves, it should say goodbye to the IMF programme. This is bad advice for two reasons. First, whatever Pakistan has achieved at the economic front in a short period of nine months, it is because of the IMF. Without its seal of approval, Pakistan would not have succeeded in floating sovereign bonds, especially in the US market. Second, Pakistan’s outstanding debt of the IMF is far more than its quota and hence it is not eligible to get out of the IMF programme.

A country like ours cannot move far ahead on borrowed resources. There is no substitute for good macroeconomic policies and solid structural reforms. The IMF programme has provided breathing space. Pakistan should use this space for far-reaching structural reforms in vital areas including the much needed tax and energy reform.

The author is principal and dean at NUST School of Social Sciences & Humanities, Islamabad.