Debt profiling: don’t repeat 2014 mistakes

BR Research December 24, 2018

The government’s domestic debt profile is increasingly skewed towards short term papers (T-Bills) – creating a rollover risk. The IMF does not like high rollover risk and may have asked the government, as a pre-condition, to move towards longer term papers (PIBs).

In principle, that is a right strategy; but the ministry of finance should not commit the same mistake made in 2014 – issuing massive PIBs at the peak of the previous interest rates cycle. Now, the interest rate is close to its peak, banks would like to have a windfall gain as they did in 2014 at the cost of government – economy at large. With no DG debt at MoF, the government seemingly lacks the capacity to handle the situation amply.

Asad Umar should take a note and should not attempt to improve domestic debt maturity profile by issuing fixed rate PIBs on Wednesday (26th Dec) auction, where the government is targeting to fetch Rs50 billion. The market expects interest rates to move further up, the participants may offer higher rates; but the government should continue the practice of rejecting the fixed rate PIBs to wait for interest rates to peak (likely in Jan19 or Mar19).

And even after that, the government should not accept fixed rate PIBs, and should rely on recently introduced floating PIBs. In order to counter the high cost of fixed PIBs in days of rising interest rates, the government last year started issuing floating PIBs. However, there is no or little interest shown by banks in floating PIBs.

It makes sense from banks’ lens to not invest in floating rates in a rising interest rates scenario. The floating bonds’ coupon rates are pegged for six months and in the last twelve months, interest rates have increased by 425 bps, why would a bank lock rate for six months when policy rate is increasing bimonthly.

Once the interest rates have peaked, banks would like to lock in for six months by investing in floating papers. However, banks would still prefer fixed PIBs, especially, at peak interest rates. The debt management at MoF job is to not let that happen. In 2014, under the IMF programme, government issued Rs2.5 trillion of PIBS which was 1.8 times the aggregate issuance of less than Rs1.4 trillion in the past 14 years i.e. from 2000 to 2013. The numbers are mind blowing and the worst part was that the government took a major interest rate hit when the interest rate started moving down.

The discount rate peaked in Nov13 at 10 percent and kept unchanged till Nov14 before moving down to bottom at 6.25 percent in May16. In the short window of peak rates (2014), banks aggressively participated in PIBs generated massive capital gains till maturity.

The PIBs issued in 2014 started maturing from July16 (as papers were not of full tenure, but rates were for long term), and since then the participation in PIBs dwindled. The government maturity profile did improve for a short span before reversing and this did not serve the purpose of improving debt profile as rollover risk was not actually lowered.

In a nutshell, it was a window dressing exercise, which resulted in additional fiscal debt servicing cost of Rs50-55 billion per year. Today, with policy rate at 10 percent (discount rate: 10.5%) – the policy rate is expected to peak between 10-12 percent and the tightening cycle is likely to be completed by Jan19 or Mar19. Seeing the subdued inflation outlook and expected improvement in current account deficit, the interest rate cycle may start reversing by Nov 2019 or Jan 2020.

The window in between could be a heaven for banks to have another windfall. But the government should learn the lesson by not repeating the same mistake; and now with new instrument of floating rate PIBs, the focus should be to make the banks to invest in these. It will serve the purpose of improving maturity profile. In case of fixed rate PIBs, any investment by banks, at peak rates, will cost government additional bucks in days of falling interest rates till the maturity of PIBs.

Copyright Business Recorder, 2018

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