Czech Republic: The case of the lost decade

In Prague, bond traders refer to it simply as "the 795", often followed by a weary sigh. The Kr5 billion ($143 million) bond issued by the Czech ministry of finance in February has achieved a degree of notoriety usually reserved for only the most ground-breaking of fixed-income deals. Unfortunately, the 795 has gained its status for all the wrong reasons - doubt has been thrown on its maturity date - and this has brought into question the procedure by which the Czech government raises cash in international capital markets.

At the January 29 auction of the bond there was no hint of the trouble to come. The five-year issue attracted healthy interest from both domestic and international investors and it looked set to be another in the long list of successful deals. But the day after the auction was completed, the first rumours of a problem began to circulate among Prague traders. Attention focused on the bond's five-year maturity.

The source of the rumours was the Czech central bank. Officials at the bank had discovered a potential problem with the issue's maturity a couple of days before the auction. They warned the finance ministry, but did not make their suspicions public until after the auction was completed.

The problem with the bond's five-year maturity was that it seemed to break the legal rules for the issue. "The ministry of finance has to have a specific law to make a new issue," explains Jan Brozik, treasurer at Czech brokerage Patria. "In the past the laws have said that they can issue, say, up to Kr20 billion with a maturity of up to 20 years."

But in the law passed last December authorizing the government to issue bonds to finance the 1997 budget deficit the usual wording was changed, and the maturity became more specific. According to Ota Otepka, a debt trader at Commerzbank Capital Markets in Prague: "The law they stuck this new issue to stated clearly that it should have a maturity of 15 years." Investors were left wondering exactly what tenor bond they had bought. Says Milan Polasek, fixed-income analyst at ING Barings: "It's still unclear whether the bond will be repaid in five years' time, or 15."

The immediate impact of the news was to send the bond's price sharply lower and make the issue virtually untradeable. "There were a few foreign investors who had big stakes and wanted to unload their bonds and couldn't do it," says Brozik.

Investors and traders alike were clamouring for the ministry of finance to take action to resolve the situation. The Czech Fixed Income Traders' Association wrote a letter to the securities commission urging action to clarify the issue. This seemed exactly the sort of situation in which the commission, barely a year old, could play its role as the new broom sweeping clean Czech markets of dubious practices.

But predictably, where government issues are concerned the commission found its hands tied. While it could request action from the finance ministry to clear up the uncertainty surrounding the issue, it was powerless to force the ministry's hand.

Traders called for the government to acknowledge the error and buy back the bond but the finance ministry refused. Even if it wanted to buy back the bond, it argued, it was unable to interfere in secondary markets.

Besides, the ministry would not accept it had made an error. In a letter to traders and investors written in the second week of March, finance minister Ivo Svoboda attempted to allay any fears by stressing the validity of the issue. According to the finance ministry, whatever the exact wording of the law it was clear to all concerned that it was always intended to allow an issue of five years, and not tie the government solely to a 15-year maturity. Svoboda and his colleagues were putting themselves in a vulnerable position by failing to take prompt action to resolve the situation.

"Before this, everyone was going to government auctions without raising any questions," Otepka at Commerzbank says. "Now everyone is going and doing real due diligence." Which is perhaps no bad thing.

Nor has demand for subsequent government bonds been affected. The auction of a Kr5 billion two-year bond in May was two times oversubscribed.

But after three months' procrastination the finance ministry has been moved to action. Amendments to several laws have been proposed. If passed by parliament (and senate and president), the amendments should mean that future laws make no mention of bonds' maturity, although the amount of the issues will still need parliamentary approval."Most market participants agree it will be a good step." says Brozik. James Rutter