Investor base widens for new EU players

Following their accession to the European Union on May 1, the next big step for the 10 new member states is to join Economic and Monetary Union (EMU) and adopt the euro. This will have a far-reaching impact on the debt issuance programmes and funding strategies of the new EU members – Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic and Slovenia.

Unlike the original 15 EU states, where Britain, Denmark and Sweden retained their national currencies, the 10 new countries cannot opt out of the euro. Yet the timing of each country’s adoption will vary between three and 10 years, according to macroeconomic and political factors in each state. Some countries, such as Estonia, have stated their desire for a swift adoption by 2007. Some, including Slovakia, hope to join in 2009, and others, such as the Czech Republic, are deemed unlikely to join before 2010.

To become an EMU member, the new EU states must first spend at least two years in the exchange rate mechanism, ERM 2. They then have to meet the strict Maastricht macroeconomic criteria on public debt, exchange rate stability, budget deficits, inflation, GDP and nominal interest rates.

Most countries already comply or are close to complying with some of the criteria. For example, all have public debt under the stated maximum of 60% of GDP. However, the most problematic criterion is the Maastricht stipulation that budget deficits cannot exceed 3% of GDP. Although some countries have got their budget deficits under control already, fiscal deficits remain a problem for the larger countries, such as Poland, Hungary and the Czech Republic.

Some bankers feel that, as countries cut their budget deficits over the next few years, their sovereign debt issuance will fall accordingly.

“By the time the countries join the ERM 2, their budget deficits will decrease, as they progress with their fiscal policy reforms and get spending under control. As they will be clamping down on spending, they will have less need to borrow, so the volume of debt issuance should fall,” says Zsolt Papp, head of Central and Eastern Europe, Middle East and Africa sovereign research at ABN AMRO.

However, other specialists expect the new members’ debt levels to rise. “All countries’ debt issuance will rise over the next few years, partly because EU accession will require capital spending on reforms, infrastructure and requirements such as Nato membership. But also, many still prioritise spending on social services, such as healthcare, over economic reforms. However, as most countries’ GDP will also rise, this will not necessarily make the budget deficits worse,” says Daniel Bytcanek, director at Slovakia’s government debt and liquidity management agency, Ardal.

Changing ratio

But whether the volume of sovereign debt rises or falls, the international versus domestic ratio of the debt will change in the run-up to adoption of the euro.

Changes in the level of non-domestic debt and also in the investor base of the 10 countries first began when they made their accession plans public. Previously, the governments issued relatively little euro-denominated debt, and what they did was sold purely to the small group of emerging markets investors. Today, however, a far wider pool of investors buy their paper, drawing comfort from the regulatory and macroeconomic discipline instilled by joining the EU.

“Joining the EU opens up the investor base to these countries. As the accession dynamic took hold, they started selling to crossover investors and then, as they got upgraded, they became attractive to high-grade investors. Finally, about 18 months ago, interest rate funds started to buy their paper,” says Peter Malik, co-head of European frequent issuer and public sector DCM at Credit Suisse First Boston.

This expansion in the investor base has had a dramatic impact on cost of funding. The spread compression on their euro-denominated bond issues has been significant. Countries such as Poland and Hungary are not funding far behind Greece and Italy now; the Czech Republic and Cyprus are printing 10-year euro bonds in the low teens over Euribor, compared to Greece at 6bps or 7bps, for example.

To take advantage of this new investor base and to diversify their debt portfolio at attractive pricing levels, the 10 accession states have increased their foreign currency borrowing over the past two years.

But they need to accelerate this strategy and broaden their international investor liquidity pool even further. Some countries see their traditional, local investor base migrating elsewhere, in search of higher yielding paper such as corporate loans, derivatives and debt from emerging market countries.

“All of the 10 accession countries need to diversify their investor base and work on international investor relationships. As our funding costs have fallen, our local investors have changed their investment strategy and their demand for government debt has fallen. We are making profound changes to our debt issuance strategy ahead of joining the euro in 2009. At the moment, 80% of our debt is provided by local investors in the domestic currency. By 2007, we want 50% of our debt to be issued in euros to international investors,” says Mr Bytcanek.

However, maintaining a balance with domestic investors without alienating them is still important. Some countries will continue to devote more issuance locally over the next year or so. “The euro, which Slovenia expects to adopt in 2007, will give us access to a broader and more diverse investor base. But our domestic investors are still important and our domestic market will remain the primary concern of our debt issuance policy in 2005,” says a spokesman for Slovenia’s ministry of finance.

Longer-dated strategy

Meanwhile, the new EU members are also looking to extend their yield curves. Some countries are far too reliant on short-term debt, as local investors have historically often preferred to play in the two- to five-year range. International markets, where investors look for maturities over 10 years, will help countries diversify the average life and final maturity of their debt and alleviate this redemption and refinancing risk. “Our debt issuance will be more focused on building the yield curve in the medium term,” says the Slovenian finance ministry spokesman.

But many expect the spread compression to continue as the countries adopt the euro, with those that are currently paying in the 13-15bps range over Euribor expected to be paying somewhere in the high single digits in the next five years. Thus they are not expected to extend their yield curve beyond 15 years just yet. “Most countries can assume that they will be AAA-rated in the next 5-10 years, so why issue a 15 or 20-year bond now, when they will get far lower pricing in a few years’ time?” says Ray Harte of EEMEA origination at Dresdner Kleinwort Wasserstein.

Ray Harte: the bigger countries will focus more on using the EuroMTS trading platform

The new EuroMTS electronic trading platform, which is dedicated to the trading of euro-denominated government securities of the 10 new states, will be a key strategy, especially for countries such as Poland, Hungary, the Czech Republic and Slovakia, which have the biggest funding requirements. “In the medium term, the bigger countries will focus more on using the new EuroMTS electronic trading platform, to ensure that they have liquid deals when they join the euro. Countries looking to join in about 2009 will want to have an established, liquid e5bn, 10-year issue trading on the MTS platform by then,” says Mr Harte.

Braced for competition

Joining the euro means entering a far more competitive marketplace, where the new members will have to compete against the likes of France for investors’ cash.

Although more international investors are buying their debt, the 10 states are still only reaching a segment of this huge new liquidity pool. After they join the euro, the 10 accession states will need to broaden their investor appeal much further, and their funding methods will continue to evolve to this end. Although historically, these sovereigns have issued local bonds via auctions, bankers say that they are likely to move more towards the syndicated method of issuance. “Investors generally prefer syndicated bonds, as they get to have dialogue with the lead banks about credit and pricing, rather than just submitting their price in an auction and either being rejected or accepted. In order for the 10 countries to be competitive in the far broader EMU pool, they’ll do bond syndications to appeal to as many investors as possible,” says Mr Malik.

Yet increased competition for investors’ funds from rival sovereigns will be offset by the huge boost in their investor base. Thus the new EU members are not expected to encounter any shortage of investors after adopting the euro. “Although it could be a slight issue for the biggest issuers, we don’t expect increased competition to be a problem for most of the 10 accession states. Our debt issuance is very low compared to countries such as France, so we benefit from rarity value. Also, our spreads will still be wider than all of the original members, even though some countries’ economies and risk are now similar to Portugal or Greece, so there will be significant motivation for investors,” says Mr Bytcanek.

Not only does ability to access financing seem assured for the new member states, but their funding costs are expected to continue to fall. “The accession states will become far more attractive to investors after adopting the euro. Only certain rate investors currently buy the 10 accession countries’ paper in their local currencies, but after the adoption of the euro, they will be eligible to virtually all of them. This far outweighs the negative impact of issuer competition. They may lose their rarity value as their euro-denominated bond issuance rises, but as their investor base deepens, their funding costs will fall,” says Mr Malik.