The Federal Republic of Germany?s securitization of e5 billion of Russian Federation Paris Club debt is a landmark transaction.
The deal creates the largest ever emerging-market bond. Arranged and underwritten by Goldman Sachs and Deutsche Bank, it provides Germany with over e5 billion of revenues while shifting the risk that the Russian debt represents off its balance sheet.
Germany sold $2.4 billion of 10-year dollar-denominated bonds, e2 billion of three-year floating-rate notes, and e1 billion of five-year fixed-rate notes. An SPV, Aries, issued the notes, which were rated BB+ by Standard & Poor?s and Ba2 by Moody?s. Russia?s payments to Germany are transferred to Aries through amortization payments. Aries makes equivalent payments to German development bank KfW. KfW hedges its obligations and then pays Aries money to cover principal and interest payments to the bondholders.
The bondholders have taken the risk because, if the Federal Republic notifies certain defaults by Russia, they can only recover 20% of the principal on each note.
The question now is, what scope is there for more of these deals? The appeal of monetizing debt that until now has been locked up on sovereign balance sheets doesn?t extend to every potential issuer. The US, for example, is unlikely to follow the Federal Republic?s lead.
?We think that the US will prefer to use bilateral debt as an instrument of foreign policy not of fiscal policy,? says Arnab Das, global head of emerging markets research and strategy at Dresdner Kleinwort Wasserstein.
The main source of this new kind of issuance will be G7 sovereigns facing a serious fiscal policy challenge. Germany itself is still in danger of breaching the EU?s stability and growth pact for a fourth time next year. So it is widely assumed that such eurozone sovereigns as France and Italy will look carefully at whether to monetize bilateral debt. France is particularly well placed to do a deal as the republic?s treasury head, Xavier Musca, also has direct control of the Paris Club division of Agence France Trésor.
If the number of potential issuers is limited, so is the number of potential obligors. The Russia deal suited Germany because Russia is Germany?s largest bilateral debtor, owing around five times as much as any other country. However, emerging Asia dominates total bilateral claims worldwide. Indonesia is the world?s biggest bilateral debtor, followed by Russia, China, India, Brazil, and Poland.
Cool reception in Moscow
Judging by its reaction to Aries, Russia will resist future deals. Aries reintroduced Russian Federation credit to the debt markets after a six-year absence. When Germany announced the deal, yields on Russian debt rocketed. Aries bonds priced at 2% over the re-offer price. By one estimate, if Germany had sold the debt where it traded immediately after re-offer, it could have saved itself a further e120 million. Although more deals like Aries might give Russia the opportunity to buy back its own bilateral debt via the capital markets, if it still wants to launch its own foreign currency bond next year, Russia won?t want to be crowded out of the market. Brazil will have similar objections.
Central and eastern European and southern European sovereigns, meanwhile, can currently borrow in euros at historically low levels of Libor plus eight or nine basis points. As the only EU accession country among the world?s largest bilateral debtors, Poland has little incentive to agree to a Paris Club monetization ? although it doesn?t have to, of course, for it to happen. France did not consult Poland when it securitized Paris Club claims against that country in 1998. That leaves China, India, and Indonesia as the most likely obligors on future deals.
Lastly, the timing of any deal needs to be right. Germany has effectively brought its claim on Russia forward. Its alternative would have been to issue a liability at its treasury rate. ?Emerging markets today trade between 200bp and 800bp over treasuries in any given currency,? says Das. ?If a future deal came at 100bp over the sovereign debt curve of the obligor country, the range of yield is between 300bp and 900bp over the curve. That cost of funding only makes sense if other specific factors are taken into account.? In the case of Aries, Germany?s difficulty in meeting its obligations under the growth and stability pact coincided with strong demand for Russian credit reflecting high commodity prices and low interest rates.
