PNG is finally approaching world financial markets for a USD 1 billion sovereign bond. This was a centrepiece of the 2016 Budget presented in November last year. A successful bond will have major benefits for PNG, especially in reducing foreign exchange shortages. However, the costs will be too high – over 25 per cent per annum – unless the Kina is made much more competitive before the bond is issued. Failing to do so will be a 2 billion Kina mistake.
There are reports that the Secretary of the PNG Treasury, Daire Vele, and the Governor of the central bank, Loi Bakani, are about to conduct roadshows promoting a PNG Sovereign Bond. Presentations are due in London on 21 June, Boston on 22 June, and New York on 23 June. It is surprising that the Prime Minister or Treasurer is not leading such an important presentation, but possibly it was considered markets wanted a more technical presentation.
PNG is likely to be successful in raising funds through the international bond – countries with even lower credit ratings have done so this year (such as Sri Lanka).
And if the government cannot raise the funds for a $US 1 billion sovereign bond, this would be a very sad result and a very bad reflection on PNG. Doing the roadshow so soon after the police shootings of unarmed university students earlier in the month may seem insensitive. But international markets frequently deal with lending countries even if there are question marks over their approach to human rights.
A key element of making this a good deal for PNG is to immediately improve the competitiveness of PNG’s economy. Improving competitiveness would be good for local farmers and local businesses. Moving the exchange rate now would lower the effective costs from around 25 per cent per annum (see below) to a more reasonable 11 per cent per annum. It would also mean the USD 1 billion bond could raise more than K2 billion extra. At current exchange rates, the bond would be equivalent to K3.125 billion. At a more competitive exchange rate (say the top level suggested by a local expert who’s firm Moni Plus is about to list on the Singapore Stock Exchange) the same $US 1 billion sovereign bond would raise K5.26 billion – over K2 billion more.
Failing to adjust the exchange rate now would be a K2 billion mistake.
This article will discuss some of the benefits and costs of the bond. Future articles will provide some information on how a rapid move towards improving PNG’s competitiveness through a once-off adjustment of the exchange rate is still worthwhile despite some of the inflationary risks (people can substitute away from imported goods towards local production) and portfolio risks (most of PNG’s official foreign currency debt is low cost from the ADB and World Bank, and other off-budget loans such as for the Oil Search shares should be currency matched on the asset and liability side).
A successful sovereign bond would be very welcome by local businesses. The greatest constraint to business has become the shortage of foreign exchange. This has been hurting jobs and growth. An extra USD 1 billion would be a welcome addition to PNG’s foreign exchange reserves and help clear some of the backlog.
The funds could also help deal with some of the cash shortages the government has been facing in paying its bills and public servants. The original intention was that most of the sovereign bond would be used to repay the very high levels of short-term Treasury Bill debt (K1.5 billion of the K2.5 billion that was expected to be raised). This debt built up very rapidly from 2013 to 2015 as the government sought to finance the largest deficits in its history primarily from domestic markets. Unfortunately, almost all of this debt build-up was for borrowings of less than one-year (Treasury Bills) rather than longer-term debt (Inscribed Stock). This led to a high “roll-over risk” and was outside of PNG’s Medium-Term Debt Management plan. The 2016 budget documents reveal that the government has to raise Kina 9,652 million in 2016 simply to rollover existing debt – most weekly debt auctions simply roll over existing debt rather than raise new money to finance the government’s still large but declining budget deficit.
The Final Budget Outcome included a tax shortfall of over K700 million in 2015, and this is likely to flow into the 2016 outcome also. Commodity prices have not been as high as expected so other revenues are likely to be lower. SOEs are pushing back on the pressures for unsustainably high dividend payouts. Given PNG’s declining fiscal position in 2016, and the reluctance to introduce a Supplementary Budget, it is more likely any Sovereign Bond funds will be used to help meet revenue shortfalls. This is especially the case as PNG moves into 2017 election mode.
Helping with the foreign exchange and cash shortfalls will be very welcome benefits from the sovereign bond. But there are costs and these could be excessively large if not well managed.
There are four costs from the sovereign bond.
The first is direct interest costs. Mongolia, with a similar credit rating to PNG, was able to raise $US 500 million in March at an interest rate of 10.9 per cent for a five year bond. This is slightly cheaper that the latest costs of PNG borrowing domestically for five years which were 11.8 per cent (based on the 2021 PNG Treasury Inscribed Stock auction of May 2016). This first cost makes the sovereign bond look like good value.
The second cost is the foreign currency risk. This is because the bond is in US dollars, and interest costs and all repayments have to be made in US dollars. The Kina has been devaluing steadily against the US dollar by 14.6 per cent per annum from July 2014. At this stage, no floor in the market has been reached. This 14.6 per cent cost per annum (or whatever the depreciation rate) has to be added to the direct interest costs. Based on current trends, that would lift the effective interest cost in Kina terms to 25.5 per cent per annum. Of course, this number depends on what happens to the Kina/US dollar exchange rate.
Market sentiment suggests the Kina still has some way to fall before getting to the level which would get back to external balance. My view is that the Kina still has about 40 per cent to move, David Kelso of Moni Plus predicts something closer to 50 per cent. At current rates of depreciation, this suggests the “gradual move” approach could go on for another three years (3 times 14.6 per cent is between 40 and 50 per cent). Below I outline an alternative strategy.
The third cost is paying the commission for the four banks that organize the bond. This is likely to be in the range of 2 to 4 per cent.
The final cost is a higher level of exposure to the uncertainties of international capital markets. Emerging markets can be treated largely as a single asset class and if sentiment turns against such assets (as it did at the start of 2016) then this can make it hard to re-finance.
Frankly, paying over 25 per cent per annum is too expensive for a sovereign bond. However, there are options which would still make the sovereign bond a sensible part of the government’s policy mix to deal with the foreign exchange and cash shortage crisis facing the country.
Fundamentally, the requirement is to deal with underlying problems rather than providing band-aids. And there are even some cheaper band-aids that are available.
The government needs to take action to improve the competitiveness of the PNG economy. This makes good sense to improve inclusive and sustainable growth. It also allows PNG to embrace the Asian century rather than moving towards autarchic policies on agriculture and land suggested by recent government policies.
As noted above, the largest cost of the sovereign bond are the foreign exchange risks. The move away from a market exchange rate in June 2014 hurt PNG’s poor. A slow, continuing depreciation of 14.6 per annum is the largest potential cost of the bond. An alternative is a once-off shift. This would be similar, although in the opposite direction and larger, to the large 17 per cent appreciation of the Kina in June 2014.
Such an exchange rate adjustment now, rather than being drawn out over several years, would immediately increase the Kina value of the sovereign bond by over K2 billion. It would also remove the largest part of the foreign exchange risk. Indeed, if the once-off move was larger than what was actually required to move PNG’s balance of payments back into long-term equilibrium, then the sovereign bond might actually cost less if the currency appreciated subsequently.
PNG is also not accessing concessional loan sources as comprehensively as it should. These are loans from the Asian Development Bank and World Bank. Such loans have much lower interest rates and much longer repayment periods. PNG needs to be better at providing counter-part funds for such loans, and also better policies in areas such as procurement.
Attracting private foreign investment is also a better way to get foreign exchange into the country. Private investors take the risks rather than the government. Such investment can also support growth and increased taxes. Of course, such investment needs to meet certain safeguards and be in PNG’s interests, but the NRI and others have raised concerns that some suggested current policies in areas such as land and agriculture could be unnecessarily scaring off foreign investment. And PNG needs more broad-based foreign investment, not just the great big projects such as Papua LNG.
The government will also have to use any borrowed funds very wisely. Some suggestions on how this could be done were provided in this paper by Professor Satish Chand, with the importance of wider policy approach covered in this internal link.
This article has focused on the public policy elements of the sovereign bond. For potential commercial investors into the bond, a more detailed analysis of the sovereign bond and its risks are available on a paid basis. This would be a small due prudence cost for potential large investors. Contact firstname.lastname@example.org for more details (some information is available at this link).