By James Beadle from Market-Melange
On 4 February, the global financial community was enthralled with Europe’s Greek Economic play. On a quieter side stage, Lithuania gave a little performance of its own. As debt markets burned, it issued $2 bln of ten year bonds. Optimists can claim a great victory. In that week a raft of IPOs were pulled globally and risk was soaring, just to get a deal away was quite an achievement.
But prices reflect risk, and so Lithuania’s achievement was not without cost. Clearly, the economic situation has improved in the Baltic region this year – the Baltic equity market is up 28% YTD, and Lithuania’s last GDP outlook is rapidly brightening. But at 7.625%, there was little sign of this adjustment in market pricing. Apparently, Lithuania paid the price of exogenous risk. Why would it do such a thing? And is Lithuanian debt really priced fairly, at such sharp premiums to other nations
with the same credit ratings?
As I have previously noted, Lithuania has been making realistic and responsible decisions throughout this crisis. In 2010 it will again have a very large budget deficit, and it is true that more could (and will have to) be done to reduce the fiscal burden, but genuine efforts to reduce government spending are underway, even in today’s tough fiscal climate. This relative dynamism inspires much interest in Lithuanian debt. But, it increasingly looks as though a return-risk premium is at play, augmenting the nation’s interest payment burden to the benefit of investors. The immediate defence might be that the market lacks awareness of Lithuanian debt, but this response is not good enough. With such a large budget deficit, the cost is too great.
Is Lithuanian Debt Overpriced?
To this investor – and apparently many others – Lithuanian debt looks very attractive. Certainly it is not without its risks: this year’s budget deficit is expected to come in at around 9% of GDP, the currency peg obliges that price adjustment transpire internally, and the government lacks a clear majority, requiring it to depend on a fragile coalition while trying to cut costs.
Nonetheless, there appear to be a couple of areas in which Lithuania’s debt management could be improved. If progress can be achieved in these areas then bond spreads ought to improve considerably, further increasing the attractiveness of present yields:
1. Issue Pricing. As the top chart shows, Lithuania’s bonds move considerably at issue. One might argue that this is exogenous (broader market dynamics) and out of the nation’s hands; but Chart 2 offers an (admittedly crude) assessment of “country risk” here, yield movements are adjusted for US Treasury and the EMBI index, theoretically eliminating both broad market and emerging market factors. While the dynamic is less aggressive, Lithuanian bonds have indeed tightened more than peers’ in early trading.
Part of this might be explained by the high issuance cost that seems to exist.
2. Market Understanding. It could be argued that Lithuania needed money and had no choice but to issue, despite the sharp rise in risk aversion in early February. But, this is not objectively clear. There are several reasons to argue that issuing $2 bln for ten years at that time was a mistake.
i. There was sufficient local liquidity available to tie the government over for the short-term. Or at least to reduce the size of issuance necessary in such desperate market conditions.
ii. Even without local liquidity, it would have been possible to issue less and wait for improved market dynamics. This need not have meant timing the market. It was clear to most market professionals (and well highlighted on Market Melange) that the spike in risk aversion was an acute event with a binary outcome (either the euro area would react and cool spreads, or would face a horrendous fiscal break-down). This should have been even clearer to the Lithuanian government, able as it was to communicate with its euro area peers.
iii. It would also have made sense to put more weight on the nearer end of the curve, eliminating some of the maturity risk paid. In fact, the cost of borrowing for ten years over five looks excessive. True, no country can finance such large debts exclusively with short-term borrowing, but if Lithuania aims to enter the eurozone by 2014, then its yield curve ought not to be so steep. True, investors may have pushed back against crowding the mid part of the curve. But, there appears to have been no compromise between maturity and steepness, and there are some spaces left on the curve.
(Political) Cost of Capital
Issuing so much debt in the middle of market turmoil remains an oddity. Since the liquidity issue doesn’t fully justify it, the best explanatory factors appear to be political.
With opposition parties in discussion about the possibility of uniting to oust the government, Prime Minister Kubilius must have felt greatly exposed to the risk of returning from the US without a conclusive result (in reality, at least partially walking away from the market would have made sense at such time). For similar reasons, the government may have played “over cautious” preferring not to wait for better times. While there is a logical case for such an argument, it seems to reflect naivety about the acute binary nature of what has been going on in the euro area in recent weeks.
Lithuania needs to fight doubly hard for every basis point in the market today, because its citizens will pay doubly for high costs of borrowing – first through debt servicing, and second through cost of capital. And as general government debt-GDP marches toward the 60% level, potential growth is in danger of declining, making it even tougher to identify attractive investment opportunities.
Stepping Forward
The underlying issue is clear. The market knows that Lithuania faces a massive challenge bringing its deficits down to manageable levels. Political stability and preliminary efforts to reduce spending have maintained a degree of market confidence. But, the tough work is still to come.
These points – and basic economic factors (see table above) – underscore that a degree of risk is merited. Nonetheless, bond trading dynamics imply that Lithuania is not making its case clearly enough.
I would argue that the risk of Lithuania not reigning in government spending and devaluing internally is not greater than the risk of Vietnam being forced to shift its exchange rate again. Vietnam does not have investment grade status, but its 10 year issue priced 67.25bp tighter than Lithuania’s, and it came to market only one week earlier!
It is highly laudable that the nation remains committed to liberal market policies. But given the corner it finds itself in, it should stand up to the market aggressively to demand fair pricing. Learning to deal with bond issuances and teaching the market about the Lithuanian investment case should not be this expensive.
The situation is clear. Lithuania is on the right path, but as the markets move from worrying about depression to worrying about the cost of fiscal largesse, so it is time for Lithuania to adapt to its new circumstance. There are more debt issuances to come, and the will price cheaper if Lithuania steps onto the front foot: broadening its lender base and expanding investor awareness of its risk-return profile. Rather than issue last minute and get caught in a bind, debt marketing and management should get proactive.
In fact, the outcome of such a campaign would lead to even greater benefits – FDI and the potential for increased tourism not least among them.
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