Posted by Joshua on Tuesday, December 14th, 2010
Syria first bond issue – A first round win for the Ministry of Finance
For Syria Comment
December 14, 2010
After three years of speculation, the Syrian ministry of Finance has finally concluded its first bond sale this Monday. As an initial step, one Billion Syrian pounds ($21 million) in both 3 and 6 month maturities were auctioned. Although the amounts are relatively small, the auction was twice oversubscribed. In other words, buyers were prepared to buy twice what the amount that was on offer. The early talk was that the Ministry was looking to sell the 3 month bills at 1% and the 6 month maturity at 1.15%. The official auction results were out today. From the standpoint of the government, it was a resounding success:
The 3 months bill auction had bids totaling SYP 2.8 billion (one billion was for sale). The lowest bid was at 0.2% while the highest was 2.5%. Four bidders were the lucky ones who were able to lend to the government for 3 months at 0.4%
The 6 months bill auction had bids totaling SYP 2.1 billion (also one billion was for sale). The lowest bid was at 0.5% while the highest was 3%. Again, four bidders were the lucky ones. Clearly, those hoping to lend (buy the bills) at 2.5% and 3% did not have a chance.
Why is this important?
Syria aims to attract as much as $55 billion in foreign direct investment over the next five years. The country also needs to finance projects ranging from power generation to new ports and other infrastructure. The powerful ministry of finance is in charge of appropriating the funding requirements for a number of these projects as well as the general budget. The runaway population growth and the extensive subsidies program (though the trend has slowed of late) will make it hard for the state to meet its future obligations. This is of course made harder by a weak tax collection framework.
Most governments use bond issuance to plug the hole between revenues and expenditures. The temptation to borrow rather than tax or cut spending is irresistible for most governments. The recent sovereign bond crisis in Europe is a prime example.
Syria of course is rather unique in having both very little foreign and domestic debt. The minister of finance is known to be a proponent of this strategy for both political and economic reasons.
The powerful Mr. Mohammed Al Hussein only agreed to sell bonds if the borrowing rate was low enough. That he was able to secure a rate as low as 0.4% is truly remarkable. How did he achieve that?
By offering only $21 million at the beginning, he wanted to make sure that the auction will be fully subscribed. It was oversubscribed. It was picked with the full knowledge that the local commercial banks are flush with liquidity and therefore had few alternatives to invest the deposits on the liabilities side of their balance sheet. The Syrian banks cannot find enough worthy borrowers to lend all their deposits too. As a result, they have been forced to deposit their surplus funds at the Central Bank, which pays zero interest. While their loan assets have been growing, they still fall short of their deposit (liability) growth. It was this dynamic that the ministry of finance spotted as an opportunity. By paying anything above zero, it offered the banks a better option than the Central Bank and zero percent. The Minister, therefore, figured that he could pay as low as 0.4% and still end up successfully selling his bonds to the banks.
The role of the state owned banks:
While we don’t know the identity of the four bidders, it is safe to assume that the state owned banks may well have been the lucky winners. These institutions are flush with deposits also earning zero at the central bank. By bidding in these auctions, the ministry of finance (an arm of the government) was able to effectively borrow from another arm of the government (state owned bank) at very low rates.
Most government bond rates work as a benchmark for other rates in the economy. The 3 month government rate in most countries is usually close to the central bank policy rate. The banks set their prime lending rates generally around 3-4 percent over their cost of funds. That rate in the case of most Syrian banks is about 3.5%. In other words, the banks pay a blended rate of around 3.5% to attract deposits (many are in checking deposits earning zero interest). In order to make a profit while they provision for bad credit and write-offs, the banks end up lending to their customers at around 8-9%. The reason the margins are around 5.5% versus the 3-4% common in other countries is because Syrian banks don’t have enough products that earn fee income. The other reason is because Syrians have never enjoyed a local bond market to invest in profitably. This is why most Syrian banks were eager to see a local government bond market develop. The thinking was that they could invest their ample liquidity in such instruments and add to their bottom line.
In order to have profited from this new bond market, the banks needed to earn a rate in excess of their cost of funds or at least close to it. What they are asked to do instead here is to lend to the Syrian government at 0.4%-0.6% while they pay their own depositors an average rate of 3.5%. Similarly, while a Syrian corporate customer may have to pay as high as 8-9% to get a loan, the Syrian government ends up paying as little as 0.4%-0.6% to borrow for 3 and 6 months.
This situation is likely to prove unsustainable for many reasons:
While the government is able to sell $21 million at 0.4% for 3 months, would the private banks be willing to participate when the amounts become larger? Will these auctions end up being bid by the state owned banks who are either morally persuaded to participate or decide to make a financial decision that the private banks would not make.
Moreover, when it comes to selling 5 years bonds, for example, what are the chances that the private banks will be willing to part with their funds at such paltry rates as sovereign credit risk increases with such maturities?
The Syrian government would only be interested in tapping the bond market in big size (to fund infrastructure etc) if it can incur very little interest costs. While this is understandable (every borrower wants to pay as little as possible), investors generally demand a risk premium and an adequate return on capital. As the bonds get longer in maturity and larger in size, private banks will continue to question the current rate structure. Expanding the buyer base beyond the banks will also be a problem. Individuals will shun this market. They can get 5.5-6.0% on their time deposits at the local banks. Why would they decide to lend to the Syrian government for so much less? This means that a secondary market for these bonds is unlikely to develop; there will be few buyers and sellers.
For the moment, however, the ministry of finance has seemingly scored a win over the banks. It has cleverly identified that 0.5% is greater than zero. The banks can either choose to leave their funds at the central bank and earn zero or they could instead lend them to the Ministry of finance and get 0.5%. For the moment at least, the score is 1-0 in favor of the ministry, but how long can the Ministry of Finance enjoy such low borrowing rates thanks to Syria’s peculiar financial markets