Sovereign bond: Opportunities and challenges for Bangladesh

Should Bangladesh expedite its plan to issue a maiden sovereign bond in the international capital market? This landmark step could actually have taken place two years ago, when the idea of issuing a dollar-denominated sovereign bond had gained strong momentum. However, authorities delayed the idea given the rising political turmoil and lower-than expected growth. This is certainly unfortunate, given in view of multifaceted gains sovereign bonds can bring to Bangladesh. Indeed the potentials of sovereign bonds have already been tapped by neighbouring countries like Sri Lanka, Pakistan and Vietnam. In this context, this brief note covers the following issues.
1.What opportunities generally offer to fiscal authorities for issuing sovereign bonds?
2. What opportunities are created for monetary authorities when their fiscal counterparts have an additional source of finance?
3.How do these benefits translate into the real sector?
4. Finally, what macro and financial challenges need to be considered while designing a strategy to issue a maiden sovereign bond?
With an external debt ratio (20 per cent of GDP) being well below comparable countries, a capital-scarce country like Bangladesh is seriously under-utilising external channels for financial resource. Currently external finance, mostly coming from bilateral and multilateral donors, is quite sporadic and require long negotiations and strict conditions. Sovereign bonds can reduce reliance on these traditional sources and allow for better fiscal planning. Proceeds from bond sales can fund government's general operations as well as finance budget deficit. For instance, target for budget deficit this fiscal year is 5.0 per cent of GDP, which is relatively higher than previous years.
Admittedly, we may see a downward revision in budget deficit this year given below-average performance in the first quarter. Yet, the government may again target 4-5 per cent fiscal deficit in the next few years to realise its goals under the seventh five-year plan. Given current inefficiencies in tax collection, fund from sovereign bonds can allow the government to meet its fiscal expenditure plans. It can also increase fiscal space by allowing the government more room to spend on education and infrastructure. Additionally, it may allow the government to gradually shift away from relying on national savings schemes (NSS), which have increased interest expense for fiscal authorities in the last 1.0 - 1.5 years.
If fiscal authorities can shift its deficit financing from domestic sources to foreign sources such as sovereign bonds, the monetary sector also stands to gain. The Bangladesh Bank (BB) has faced numerous challenges in trying to reduce inflation while supporting growth. The BB's latest monetary policy came under fire as many stakeholders demanded higher growth in reserve money - BB's operating target - to fuel demand. If the BB wants to stimulate private demand, it has little scope to reduce inflation since it cannot lower reserve money growth. It would appear the age-old Philips Curve argument of "higher growth requires higher inflation" has put the BB in a tight corner. Yet sovereign bonds, if utilised to finance fiscal deficit, can create the space the BB needs to circumvent the above dilemma.
Reducing inflation requires a reduction in reserve money growth. Reserve money growth consists of credit to the private as well as the public sector. Current monetary policy targets a higher growth rate for credit to the public sector than private sector. If the government can finance US$ 1.0-2.0 billion of its budget deficit from sovereign bonds, the BB can reduce its growth in credit to the public sector. With strong fiscal-monetary cooperation, a reduction in credit growth to the public sector (parallel to rise in sovereign bond sales) will lower reserve money growth without reducing credit growth to the private sector. Over a medium-term plan, a substantial reduction in public sector credit growth can allow the BB to reduce reserve money growth to around 14 per cent (from current level of 15 per cent), while keeping its credit growth rate for the private sector unchanged. This will allow monetary authorities to reduce inflation faster than current targets, while supporting private sector investment and growth.
How can the benefits to fiscal and monetary sector spread to the real sector? First if the government utilises sovereign bond proceeds for productive fiscal expenditure, the real sector will be directly benefited. We all know the current subdued investment scenario is largely attributable to the lack of adequate energy supply and better infrastructure. There is also concern about low allocation of fiscal expenditure to the education sector - sovereign bond can potentially help mitigate these long-standing issues. Second, if monetary authorities can bring down inflation through lower credit growth to the public sector, borrowing costs for the private sector firms should also go down. Lower inflation can allow banks to reduce lending rates, while keeping its real lending-rate unchanged. This will increase credit demand from local banks and increase growth-enhancing investments. Third, a sovereign bond will serve as a much-needed benchmark for private sector bond issuers. Recently, a telecom company in Bangladesh issued the first-ever high-yield bond in the international capital market. But without any sovereign-bond, international investors got little reference while determining its valuation. Fourth, a sovereign bond will improve foreign investors' confidence in Bangladesh and attract FDI that the real sector needs at present. Finally, if these benefits are realised, Bangladesh's sovereign rating could also increase which will further attract foreign capital.
Now, what macro and financial challenges need to be considered while designing a strategy to issue a sovereign bond for the first time?
With the US economy gaining momentum, some analysts may fear that Bangladesh's sovereign bond may not attract enough demand. This argument is not without merit, given that international investors are well aware that the Federal Reserve will continue on a regular path of interest rate hikes to bring short-term rates to around 2.0 per cent  by 2017 (for details, see "Fed Dot Plot"). Why would investors want to allocate their capital to what is an unknown financial asset (Bangladesh sovereign bond) when they can get useful returns from what are considered among the safest investments in the world (US government debt)?
To overcome this issue, an operational plan focusing on raising demand for Bangladesh sovereign bond needs to be outlined. This will involve choosing potential target classes of investors - global, regional, institutional, retail or a combination of these investor classes. Then, a strategy has to be developed to introduce the country to potential investor classes through easy access to information on sovereign rating, economic growth, macro stability, political conditions and other similar relevant indicators. Easily accessible databases consisting of all relevant economic information should be readily available on the websites of major regulatory authorities.  The BB, for instance, has certainly taken commendable initiatives on this front.
Given that Bangladesh's sovereign bonds should pay at least 5.0-6.0 percent, investors keen on diversifying their portfolio to an economy which is largely insulated from global financial shocks, are expected to find Bangladesh's sovereign bond quite attractive. Higher US interest rates should not make it difficult for Bangladesh to sell its bonds as shown by international experience. For instance, Vietnam issued its maiden dollar-bonds successfully in 2007 -before the global financial crisis when US short-term treasuries were offering around 2.5 per cent return. If a corporate issuer from Bangladesh (mentioned above) can successfully raise capital from the international market, a relatively risk-free government bond should certainly be able to do the same.
With regard to the financial characteristics of the bond, authorities have to make critical decisions in terms of size of issue, coupon rate and maturity of the bond. Too high an issue may create problems related to repaying the debt. Excessively high coupon rate can also be an additional source of burden on government's financial plans. Short maturities will lead to well-known challenges of maturity mismatch.
Looking at cross-country comparison of selected comparable economies, we see that a sovereign bond roughly 1.0-1.5 per cent of GDP can be quite suitable. This view takes into consideration that external debt is at 20 per cent and has room to grow by around 2.0-3.0 per cent without creating any financial challenge for the government. Regarding the coupon rate, one would expect given low-interest rate environment of the global economy, that of Bangladesh should actually be lower than most of the countries shown in the table. While this will eventually be decided by perceived macroeconomic stability in the country, a coupon rate of around 6.0 per cent seems justifiable. In terms of maturity, authorities should prioritise 10-year sovereign bond given that public expenditure in Bangladesh is slightly slow in terms of implementation and resulting income may also come with a larger-than-expected lag. A 5-year bond may create pressures related to maturity mismatch and so a 10-year debt gives significantly longer time to generate the cash flow needed to repay the liability.
In conclusion, Bangladesh needs to expedite its plans on integrating itself with global financial markets if it wants to increase investment ratio to well above 30 per cent of GDP. Certainly there is a limit to how much growth domestic resources can generate, and the long-standing trend of 6.0-6.5 percent growth rates suggest we have reached that threshold. Foreign capital, in the form of sovereign bonds, can open up multifaceted opportunities for the economy if properly utilised. Will our policy-makers rise up to facilitate this journey and help Bangladesh attain the elusive 7.0-8.0 per cent growth?  
Sharjil Haque currently works as a Macroeconomic Analyst for an organisation in Washington D.C. He is a Fellow at the Asian Centre for Development in Dhaka.
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