No such thing as a free lunch!

The Government of Malta announced last week that it will be seeking to raise up to €168 million in new government stocks spread over three issues. The first is a 4.25 per cent November 2017 issue. There is already a similar issue trading on the MSE at the moment. The second issue is a new 5.2 per cent 2031 bond, to be priced, most likely, at par or slightly below.  A floating rate note will also be issued, maturing on November 23, 2014. It is expected that €24 million of this stock will be issued.

As we all know (unless you are Greek), debt must be repaid in full at some point- David Curmi

The issue of such stocks has focussed some investors’ minds onto the state of the government’s finances. With all the shenanigans on display in Brussels it is not surprising that questions arise. This is to be expected. Risks in the sovereign debt sector have risen and with media coverage analysing every move with a fine tooth comb, investor awareness of many of the challenges has risen across the board. This is a good thing.

As recently indicated to varying degrees by the three main rating agencies, the Malta government is facing challenging financial times.  While Moody’s has downgraded Malta’s credit worthiness, S&P and Fitch have opted not to. There are two critical issues to assess. The first is the creditworthiness of the country, but the second is a much more fundamental issue. Government bonds (especially those of developed countries) have always been considered “risk free”. Do we really mean that such investments are without risk?

Malta is currently running a debt to GDP ratio of 68 per cent, similar to that in 2010.  These are good figures, especially when one considers the stage of the economic cycle that we are in and the challenges that are being faced. Furthermore, the Maltese banking system has remained flush with cash which has enabled the government to tap almost exclusively domestic investors when issuing bonds. This is a significant advantage that has afforded government protection from the substantial downward price movements seen in some other European markets.

This “buffer” has also ensured relative stability in government’s cost of capital, in that it can be assured of a ready and willing investor base that remains prepared to buy its bonds.  Italy is fast moving perilously away from this comfort zone with its 10 year government bonds yielding over 6.6 per cent on Monday. By contrast Malta is issuing 20 year bonds at sustainable yields in the region of 5.2 per cent. I have no doubt that there will be immense demand for this paper when applications open.  We must not be complacent.  Risks are rising, not only in the context of the euro countries but also domestically.

Malta’s debt burden has risen 50 per cent to €4.3 billion since we joined the EU and by 21 per cent since joining the euro.  Meanwhile one of the benefits of the euro has been reduced interest rates, but the sheer amount of bonds issued has more than outweighed this benefit. This has been a common occurrence within the EU and has contributed to the severe stress of EU government finances.

Low spreads over German bonds were like Christmas come early for bureaucrats. Countries embarked on borrowing sprees to boost government spending.  Alas, as we all know (unless you are Greek), debt must be repaid in full at some point.  Rolling debt over ad infinitum is not always an option, as many countries which have seen their borrowing costs soar, recently found out.

Where does this leave us?  Certainly not out in the cold by any stretch of the imagination but the government needs to be prudent in its approach to future finances. Though our market has been kind to them, this may change at some point. Spare cash is increasingly becoming a rare commodity. At the same time the number of banks competing for this cash has grown considerably. One option may be to consider a new registration scheme to attract more of the cash hidden away internationally into the domestic economy.

The pressures on international banks, especially in Switzerland, combined with the need of many to feed cash into their businesses here in Malta have served to create a somewhat ideal moment to do this. It is true that Malta has been criticised internationally, most recently within the Moody’s  report that the country’s finances benefit from a series of one off transactions, but the reality is that domestic interests should take hold. Additionally protective measures can ensure that this cash does not end up in the wrong place.

With risks in sovereign debt markets having reached such extreme levels in Europe, is government debt still risk free?  So far this has always been the case.  One need only look at Basle I/II rules or the Solvency II regulations issued by regulators and central banks to realise that this is a cornerstone of financial regulation. Insurance companies or banks have traditionally benefitted from holding government debt instead of corporate debt as the “haircut” on such bonds, when calculating capital requirements is usually zero.

This has encouraged such institutions to hold government debt and perhaps also encouraged them to be more complacent about such bonds.  True, such bonds are generally more liquid but the dynamics  of government finances have proved that, in many cases, governments have proved incompetent stewards of finance.

Any change towards accounting for this risk will have far reaching implications for the financial system but change must come if we are to take into account the realities of the day. Clearly there is no such thing as a free lunch.

This article is the objective and independent opinion of the author. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment.

www.curmiandpartners.com

Mr Curmi is managing director of Curmi and Partners Ltd.