Wednesday, July 20, 2011

Another sovereign bond issue

Sri Lanka has launched another $1,000m bond, the fourth international bond since 2007.

The issue is being managed by Bank of America, Merrill Lynch, Barclays Capital, HSBC, and Royal Bank of Scotland. Some of the banks: Bank of America, Barclays and Merril Lynch are new entrants to Sri Lankan bonds, the weaker market conditions overseas probably necessitating the larger number of players.

What is interesting is the absence of China.

China is the government's lender of choice, politicians are constantly touting the virtues of easy credit from China which goes hand-in-hand with political support at tricky international forums. The Chinese lend freely and ask no questions, a borrowers delight.

Yet, when it comes to raising bonds, the government turns to the hated West. Western banks are used and the bonds expected to be sold in the US, followed by Asia and Europe. True, they have not included the banks involved in the oil hedging deal (Citi, Deutsche and Standard Chartered), but these banks (except Citi) never bid to manage the sovereign bond issue anyway.

So, why turn to the West? Expertise? Certainly, these banks are used to structuring and marketing these products but why pay fat fees to banks and incur all the costs of international roadshows when we could simply issue bonds direct to our friend China?

Could it be that China is not particularly interested in these bonds?

China is now this country's main creditor, but the bulk of the lending is project based - for infrastructure, highways, ports, power plants and the like.

The Chinese loans are tied, meaning that the projects need to use Chinese raw materials, (steel, cement etc) and even a fair component of Chinese labour. The proportion of local value addition in these projects is a great deal less than in projects involving international lending agencies.

Thus China earns a return on its loans both in the form of interest (at commercial rates, unlike the subsidised rates offered by lending agencies) and profits on the raw material sold to the project. These projects are therefore a lot more profitable than subscribing to a straightforward bond. It may also be more secure - I do not know if the project assets are mortgaged to the Exim bank (the main lending arm the Chinese) but it is a possibility. Apart from return and security there is another reason why they may not wish to subscribe.

The Government has to have a 'story' to sell a bond and merry tales of reconstruction and infrastructure can be spun. The story only has to be believable to in order to sell, no one really monitors if the money is spent in that manner. What actually happens is that the much of the funds are used to pay interest, roll over existing debt and pay for salaries and other day-to-day expenses.

In terms of an ordinary household, the country is not borrowing to repair the roof, extend the house or buy a labour saving device like a washing machine. We are borrowing in order to buy our food and pay our living expenses, not to invest.

Perhaps the Chinese are willing to finance our infrastructure, at a price, but they may be less willing to finance our consumption, leaving that task to the international banks and bondholders.

As long as the debt is serviced, ultimately from taxes raised from the populace, the banks and bondholders will have no problem but the first sign of trouble will see them flee to the exit, probably sending the rupee to free-fall.

Update: The bond was sold at 6.25%, compared to US treasuries which are currently at 2.96%, full story here.


n said...

Nice summary. Now if this could only be translated so the local johny on the street could understand it.

Anonymous said...

I suspect that some of the money raised will go to repay the very same people. Some of it might even come back.

Jack Point said...

Thanks n.

Anon, a distinct possibility.

I believe old bonds to around $1000m also need to be repaid next year.

sbarrkum said...

You may want to read this too
How China Ate America's Lunch

In 1978, the year China emerged onto the world stage with its four modernizations, China, a country with four times the population of the United States, had a paltry gross domestic product of $216 billion, less than eight percent of the United States. China exposed her strategy of four modernizations to the world as if to say, “Please invest in China and we will ensure that our workforce is educated, and that our business infrastructure is stable for your investment.”

n thirty short years, China was able to accelerate her GDP from $216 billion to $11 trillion. She amassed reserve capital of $3 trillion. She reversed America’s fortunes from the greatest creditor nation to the greatest debtor nation. She gutted America’s factories while creating the world’s largest manufacturing base in her own country. A measure of output that highly correlates to GDP is energy consumption. In June of this year, 2011, China surpassed the United States as the largest consumer of energy on the planet. While the U.S consumes 19 percent of the world’s energy, China consumes 20.3 percent.

Jack Point said...

Thanks for that link sbarrkum. Trade is not a zero sum game. Trade benefits everyone, if it did not it would not take place.

No one forces Americans or Europeans to buy Chinese products or force overseas investors to invest in China.

The Chinese have benefited from rising living standards due to increased employment in these new factories while Americans and Europeans have enjoyed better living standards due to cheaper products, from clothes to electrical appliances to cars and toys.

Dilly said...

Really informative piece. Yeah as N said, wish there was a way the local Johnny and Jane could be given this information in a way they can digest it. People get swung by rhetoric because the alternative, which are facts and policies aren't given to them in a language they can understand. Or so I'd like to think.