Is it the right time to refinance?
The issue of refinancing the government debt and returning to market financing has become important in Latvia of late: the government is planning to terminate borrowing from the European Commission (EC) and the International Monetary Fund (IMF) and tap international financial markets for the needed funds instead. On 28 April, news agencies disseminated information about Latvia eventually issuing Eurobonds, i.e. securities, worth 500 million US dollars in May or June of this year.
Latvia is unlikely to pay off the accrued external debt in one go, for it would require large funds to be accumulated from the budget surplus. This assumption is underpinned by the fact that, for some years at least, the country will apparently spend more than it earns, with the reduction of budget deficit in several gradual steps. The lack of funding is to be offset by more borrowing; meanwhile the time is ripe for repaying the funds already borrowed from the EC and the IMF. That is why, the existing debt will have to be refinanced to pay off the money borrowed under the international bail-out programme by undertaking new debt obligations against financial market investors or, as is the case of Latvia, by issuing Eurobonds. It is obvious, however, that in the circumstances of government budget cuts and a balanced economic growth regular refinancing of the government debt may make the latter rise; the debt-to-GDP ratio, on the other hand, will decline and become sustainable. Protractedly pursuing prudent and reasonable financial policy, the country can arrive at a favourable debt-to-GDP ratio.
A country may borrow either from the domestic or external financial market; albeit in Latvia the domestic financial market is not sufficiently large to meet the demand. Pension funds globally rank among the most significant sources of accumulated funds; Latvia, unfortunately, has cut the second pillar contributions from gross wages from 8% (projection at the launch of the pension system) to 2% (for 2011 and 2012), which reduces the size of accumulated funds and impairs the development of the local financial market. As a result, the domestic financial market is not strong enough to issue new debt securities worth several million or even a billion lats within one year. With regard to the numbers, it should be noted that in 2010 the general government budget deficit to be financed by borrowed funds stood at 803 million lats.
In the context of international loan refinancing, important is the issue of when to borrow. The currently close-to-historical-low short-term interest rates on euro and US dollar loans seem to be in favour of the government plans to issue Eurobonds. However, as inflation risks increased in the course of the past year, central banks can be expected to raise their interest rates in the future (well-confirmed by the ECB lately raising its base rate). This could serve as a well-justified trigger for a sooner issuance of government securities into the international financial markets. Nevertheless, the interest rates on loans in some currencies are not the sole factor determining the issuer's rate; hence the reasons in favour of postponing borrowing to a later time should also be considered.
First, the amount of currently available budget resources, i.e. the income from taxes and borrowed funds, are sufficiently comforting to refrain from borrowing in the upcoming months. The government must pay interest on already borrowed funds, which increases the debt servicing costs, therefore the decision of taking a loan and not using it for a protracted period of time must be seriously weighed up. Moreover, from a seasonal perspective, May has always been a month of relatively good budget revenue due to appropriation of state capital companies' profits to the state budget. Consequently, from the point of view of funding needs, it might be more rational to postpone borrowing to a later time.
Second, given a postponed borrowing, Latvia will benefit from its own improved credit rating. Overall, the terms of borrowing depend on a country's macroeconomic performance and the related sovereign credit risk. Latvia's macroeconomic situation is progressively improving; hence its credit risk is abating, with the process most likely to go on also in the future. (For instance, the margin of credit default swaps in Latvia has dropped around 1.2 percentage points and currently stands at 2.2%. It is expected to decline further over the coming 12 months). Latvia's borrowing costs will be determined by the size of its budget deficit, the amount of debt, and the commitment to proceed with the reform process in the future. In the case of optimistic scenario with a timely passed budget for 2012, Latvia has every opportunity to improve its credit ratings, which, in turn, will reduce credit risk margins vis-á-vis the current level and make the borrowing cheaper.
Third, the short-term interest rate hikes should not be automatically attributed to the long-term rates, for Latvia is going to borrow for a protracted period of time. At this juncture, the global interest rate hikes are widely discussed, yet they mostly refer to central bank rates likely to affect seriously the money market or short-term rates as well. Market analysts predict that the euro base rate could have doubled, reaching 2.50%, by September 2012. Meanwhile, according to market agents' forecasts summed up by the news agency Bloomberg, the long-term interest rates, those on the German government 10-year bonds among them, could increase to a lesser extent, i.e. by around 0.7 percentage point, over the same period. The future global price dynamics and fiscal consolidation levels in the EU countries are also surrounded by uncertainty. The economic growth in the next decade in industrialised countries should rather be forecast in the amount of 2%–3% instead of 5%–6%; in such circumstances, inflation and interest rates are unlikely to be high. Consequently, the rise in the market key rate, a component of Latvia's Eurobond rate, may be limited in the future.
Fourth, this year, which is the concluding in the international loan programme, Latvia has access to the IMF and EC funding. Borrowing under a fixed interest rate, the EC and IMF funding might prove to be notably more favourable for Latvia than the Eurobond issuance.
Fifth, low interest rates in the future depend on Latvia itself. If the country convincingly demonstrates its commitment to reduce the budget deficit and to change over to the euro, debt refinancing, which will become genuinely indispensable in 2014 and 2015, will be possible at lower interest rates. (In 2014 and 2015 on an annual basis, debt obligations in the amount of around 1.1–1.2 billion lats will have to be paid off).
In the course of three years, the government debt has grown fourfold, from 1.3 billion lats in 2008 to 5.7 billion lats now. Having borrowed from the EC and the IMF, Latvia in fact bought time for gradual reduction of its budget deficit and implementation of reforms; hence it would not be wise to waste the concluding phase of this period. A slow reduction of budget deficit as a rule translates into higher debt amount and debt servicing costs. Latvia's debt servicing costs for 2011 will amount to 270–300 million lats or six times above the pre-crisis level. The funds spent on debt servicing could be more usefully channelled into the economy and welfare: every year, similar amounts of money are required to ensure health care (250 million lats) or to pay salaries to teachers (216 million lats). As the budget deficit boosts the government debt, the latter is projected to soar by about 730 million lats within the year, to exceed 6 billion lats.
By refinancing the debt, the government intends to escape from this unwelcome frame by all means. In order to succeed, a precondition is to re-borrow at low rates. Low rates are becoming of credible borrowers. At present, Latvia's credit ratings that financial markets are able to see have just started to improve and, due to the budget deficit, debt and unaccomplished reforms are currently lagging behind Lithuania and Estonia by 2–5 degrees. It is obvious that a balanced budget and the changeover to the euro in 2014 are going to improve the sovereign credit ratings, automatically implying lower interest rates and, hence also easier debt repayment, without giving away the money that could be more effectively used for the needs of the domestic economy.
This article was published in Latvian on the website of Delfi on Mai 17, 2011.