Chopping apple tree for firewood

Source: http://dawn.com/2008/04/21/ebr2.htm

By Dr Zafar Iqbal & Hasaan Khawar

THE government is considering raising money through exchangeable bonds from the international financial market. An exchangeable bond comes with an embedded option to exchange the bond for the stock of a company at some future date under certain terms and conditions.

The company linked with the proposed exchangeable bonds, in this case, is likely to be Oil and Gas Development Company Limited (OGDCL), a prized strategic asset with majority share held by the government.

Apparently, the option of exchangeable bonds has surfaced after the government has been advised by some foreign banks that the other alternatives may not be viable. Despite the urgency and gravity of the matter, the government must consider a few key questions, before going for such an option. While on the broader level, the issue a fortiori, highlights the need to review the overall finance and debt policy on the micro level, it raises some important questions like why, if at all, the exchangeable bonds are more feasible than other options.

What is likely to be the impact of such a step on OGDCL’s shareholding? Are there any alternative options, which are better than exchangeable bonds? And last but not the least, is such a step aligned with the privatisation policy?

Last time, in 2004 when Pakistan ventured into the global debt market by launching Eurobonds worth $500 million, the foreign exchange reserves were at $12 billion and rising. The Eurobonds offering resulted in huge over-subscription, which was seen by the then government as a sign of confidence of international financial community in Pakistan’s economy.

The critics however, at that time, questioned the rationale behind raising money from the international capital market in the presence of such a heavy pool of foreign exchange reserves. The government was quick to defend its policy and claimed that the reasons for raising money were strategic in nature as the country was coming out of IMF’s programmes and such a step would set the tone for future capital-raising initiatives.

Unfortunately however, only four years later, the strategic premise, taken by the last government, seems to be falling apart, as the government has been advised not to float Eurobonds. Moreover, the widening current account deficit, poised to exceed $12 billion for FY 2007-08, has also raised serious questions about how much money the government is planning to raise through these bonds. The situation might be an indicator of the real story behind the widely acclaimed economic success of the last government. Evidently, the options of floating Eurobonds and ‘Sukuk’ - the two other alternatives considered by the government - have been discarded due to the global credit crunch. The international capital market is going through a severe crisis, ever since the defaults in the sub-prime loan market started sending the exposed banks into a tail spin with Bear Stearns as the most recent victim. As a result, the spread between the lowest investment grade bond and the US treasury in the 10-year segment has more than doubled from some 1.5 roughly a year ago to around 3.4 per cent more recently, making the capital even more expensive.

As a reference point, last time, the government ventured to raise dollar debt in the international capital market, its bonds were rated B+ i.e. below investment grade. More recently, the debt traded at as high a spread as 4.4 per cent over US Treasuries. This problem is further compounded by the fact that Standard and Poor’s has maintained a negative outlook on Pakistan, quoting economic and political risks facing the newly elected government. While all these reasons can be cited for not floating Eurobonds, which are a form of unsecured bonds, one may wonder why the ‘Sukuk’, the Islamic form of secured bonds offering a protection to investors against default, are ruled out given the phenomenal growth that this sector of Islamic finance has experienced over the past some six years, especially in the Middle East.

Even if the reason for global credit crunch for not floating Eurobonds and ‘Sukuk’ is accepted on its face value, one may question the rationality behind floating exchangeable bonds and not going for other alternatives. The exchangeable bonds yield lower than the bonds of comparable maturity and risk but give the holders the right to exchange their bonds for the shares of a company at a pre-specified price. They not only give the investors option to invest in a company but also offer some inflation protection, as the exchangeable bonds trade like bonds when the share price is far below the exchange price but trade like stocks when the share price is above the exchange price.

While this is a reasonably attractive proposition for investors, it lowers the cost of capital for the borrower but caps its upside gains on shares to the conversion price. One therefore, may argue that if the exchangeable bonds offer the right to bond holders to buy the shares only on the upside, i.e., if the shares are doing well, why the government instead is not considering offering Global Depository Receipts (GDR) for OGDCL instead of floating exchangeable bonds.

If, however, it was felt that the time was not ripe for such an option then one innovative method worth evaluating is increasing the leverage of OGDCL through an international corporate bond issue, the proceeds of which are paid out in dividends to the shareholders with the government as a major beneficiary.

Another possible option, which apparently the government has disregarded so far is private placement of the government bonds, which may be far better considering that only a few years ago, the Eurobond offering was more than four times over-subscribed. One final thought in this regard could be to tap foreign currency holdings of non-resident Pakistanis through attractive long-term deposit schemes, an option that India once actualised successfully. Needed also is a close examination of the ‘Hundi’ channel so as to come up with methods to route it out to improve slippage in remittances.

Coming back to the issue of exchangeable bonds, it is also not clear that how the proposed offering is linked with the privatisation policy, currently under review. Mr. Naveed Qamar, who has recently taken over the portfolio, has vowed to make the privatisation programme more popular among the people and to transfer its benefits to the common man.

OGDCL is a strategic asset for Pakistan and is the local market leader in terms of reserves, production and acreage. In an environment where industrialised and fast growing industrialising countries (e.g. China) are building stakes in the oil sector worldwide, any decision to privatise OGDCL must be critically reviewed and be made part of the overall privatisation policy.

Linking OGDCL’s shares with the issue of exchangeable bonds is likely to put OGDCL on a tight leash, as the exchangeable bonds generally ensure the holders protection against equity dilution, hindering the future privatisation efforts for OGDCL.

The decision to offer exchangeable bonds therefore needs to be critically evaluated to see if it really is the best option to raise money. Above all, the policy of debt financing and debt management itself should be thoroughly examined to make sure that as a nation, we are not chopping up the apple trees for firewood. ( The writers are faculty members of FAST-NU, Lahore campus.)