Emerging markets: India; Peru; Saudi Arabia; Russia

Politically correct about debt

The door is slowly opening on India’s debt markets. Foreign investors can now invest 100% of their Indian portfolios in corporate debt as against the 30% allowed previously. The market itself is booming with long-term debt worth rs55 billion ($1.54 billion) raised by Indian corporates in the past few months and fixed-income returns overtaking those of equities.

The excitement in the corporate sector has set analysts wondering whether India’s government bond market – accounting for 60% of total issuance – could also be ripe for reform. But India’s finance minster p Chidambaram is cautious about this prospect.

“It’s a suggestion and as we say in parliament it’s a suggestion for action. We have to consider it before we take a decision. No decision has been taken yet,” he said during a visit to London in September.

He added: “Initially we allowed fiis [foreign institutional investors] to invest up to 30% in debt instruments. We have now increased this to 100% in debt instruments [excluding government bonds]. Let’s see how this works. Let’s see the flow of funds. One step at a time is what is politically correct in India today.”

The driving force behind India’s debt market reforms is the need to raise capital for infrastructure projects. “India needs about $300 billion over the next 10 years for infrastructure alone,” says Dennis Grubb, a Price Waterhouse consultant who heads up the Financial Institutions’ Reform and Expansion project, sponsored by usaid and the Indian government. “Only half of this can be raised from the commercial banks, the equity market, the government and multilateral agencies like the World Bank. The other half must come from its domestic debt markets.” The Indian debt market is too small to meet this requirement, says Grubb.

But the market is headed in the right direction and bonds – not shares – are the hottest selling investments in India today. In the past equity markets have overshadowed debt in both size and returns. While India’s total stock market capitalization at $138.6 billion still dwarfs that of the debt market at $84.03 billion, analysts say that investors are increasingly choosing bonds over equity.

According to Prime Database, a primary market monitoring agency, cash raised through initial public offerings fell 47% to rs48.76 billion in the six months ended June 1996 against rs91.17 billion in the same period last year. Of the total rs16.74 billion raised from the capital markets in the month of August, 78% or rs13 billion was raised in debt floats, it said. Returns on debt are also higher than from equity, according to a study by securities firm icici Securities and Finance Company (i-Sec), which has a tie-up with jp Morgan. The study which tracked the Bombay Stock Exchange index and returns on fixed income securities over a 42-month period from January 1993 to June 1996 found that the annualized return from fixed income investments was over 16% compared with 13.55% on index-linked stocks.

Retail investors’ enthusiasm for debt is echoed by the efforts of India’s coalition government to revitalize the capital markets. Emboldened by a decline in external debt to $92.6 billion and debt service ratio to 26% last year, the Indian goverment introduced its latest reforms.

While major investment banks welcomed these as a step forward, two major hurdles remain. The government bond market is still closed to them. Says Barrows Hall, head of Morgan Stanley India Securities: “The focus of attention of most international investors in debt is the government bond market.”

The other problem is liquidity. Most retail investors are not looking at exit options or taking a long-term view on interest rates, says lk Narayan, vice president at dsp Financial Consultants. Allowing market-making in government securities is the key to creating an active secondary debt market in India, Hall adds.

Secondary market trading in debt is limited to government securities and is done mainly on the wholesale debt market of the National Stock Exchange. Average traded value in debt on the nse in August this year was just rs1 billion as compared with rs13 billion in the equity market. However, things are set to change with the Bombay Stock Exchange kicking off its debt segment in September.

Last year, the Reserve Bank of India – the Indian central bank – set up a system of primary dealers or market makers in government securities. But for debt trading to take off, several structural changes need to be put in place, says Price Waterhouse’s Grubb, including setting up a depository and establishing a repo market.
Kala Rao

PERU

Growing pains

In Lima, shopping in the streets is a way of life. You can buy anything from chewing gum to computers from the vendors who crowd the city’s thoroughfares. So it is not surprising that on the sidewalks outside the Lima Stock Exchange a crowd of touts importune passers-by with offers to buy or sell shares of Peruvian companies.

This unregulated street trade is an embarrassment to the authorities who supervise the Lima exchange – over the past five years one of the fastest growing and most profitable bourses in the world. By law, only registered brokerage houses can trade stock and Conasev, the government agency that regulates securities trading, periodically carries out raids to stamp out the illegal traffic. In May, for example, 23 vendors were rounded up.

The persistence of informal stock trading illustrates the contradictory nature of the Peruvian stock market – what at the beginning of the decade was a sleepy backwater has been rapidly transformed into a bustling market drawing attention from investors around the world. Authorities have worked hard to upgrade the exchange, putting into effect modern securities laws and installing a computerized trading system. But the market still suffers from sharp volatility, illiquidity and such idiosyncrasies as the street trade in stock. “The boom hit a market that wasn’t completely prepared,” said Conasev general manager Victor Loayza Moreano in a recent interview.

The transformation of the exchange dates back to the coming to power of Alberto Fujimori as Peru’s president in 1991. The country was then an international pariah, a result of the confrontational policies of former president Alan Garcia. Fujimori adopted a strict, market-based economic programme, slashed hyperinflation to single digits, reignited economic growth and normalized Peru’s relations with the international financial community. His government also captured leaders of the menacing Shining Path rebel group, restoring central authority throughout most of the country. In 1991, an updated securities law was enacted, establishing listing and disclosure requirements similar to those of developed markets and restricting securities trading to licensed brokerages. Foreign investors were encouraged in with tax benefits and free repatriation of profits.

The reforms had the desired effect. Between the end of 1991 and 1994, the Lima exchange’s general index (igbvl) shot up 1,329% in real terms, while trading volume soared nearly six-fold. Market capitalization leapt from just over $1 billion in 1991 to $8.1 billion in 1994. Activity was fuelled by a stream of privatizations, especially in telecommunications, electricity and mining. Typically, majority interests were sold to strategic investors while minority shares were publicly offered.

Since the Mexican crisis late in 1994, Peru’s market has been in a period of consolidation. Trading volume has continued to increase, amounting to $5.280 billion in 1995 and $3.606 billion in the first half of 1996. Market capitalization reached $13.7 billion by midyear. But the market’s rise was cut short. The igbvl traded between 900 and 1400 through most of 1995 and early 1996, held down by a border war with Ecuador and slower economic growth. The price/earnings ratio for the market, which exceeded 25 during the heady days of 1994, fell below 10 late last year.

Lately the market has recovered its vigour. From a low of around 1200 in March, the igbvl surged to the 1570 level in late September. Analysts say stocks have been boosted by a successful restructuring of Peru’s debt to the sovereign creditors of the Paris Club and the oversubscribed sale in June of government shares in cpt Telefonica del Peru.

Despite its strides, the Lima market lags the bigger Latin American exchanges. Only about a dozen of the roughly 200 listed stocks are actively traded. “Liquidity is concentrated in a very small number of issues,” says Pablo Moreyra, a Lima-based analyst with ing Barings. Among the most actively traded shares are Telefonica; Backus & Johnston, Peru’s largest brewer; Credicorp, the holding company for Banco de Credito, the country’s leading bank; Southern Peru Copper Co; and the mining company Buenaventura. Telefonica, Southern Peru, Credicorp and Buenaventura, as well as Banco Wiese, the country’s second largest bank, list adrs in New York.

While foreign participation has mushroomed, the local market remains underdeveloped. A large portion of locally-owned stock is held by Peruvian financial/industrial groups which have only just started trading their shares. Until recently, few middle-class Peruvians owned stock. Of those who did, many preferred to do cash transactions with street vendors rather than using brokers, who take three days to settle. “Consciousness of the market is increasing, but many people think it’s just for the rich,” says Cesar Helfer, a Lima stockbroker.

On the other hand, a measure by Peru’s leftist military government of 25 years ago to force companies to distribute a special class of non-voting shares to workers has increased liquidity by putting stock in the hands of ordinary Peruvians. In addition, Fujimori sponsored legislation in 1992 creating a private pension fund system. About half a dozen are now operating, helping to raise trading volume.

The year’s biggest deal – the government’s $1.1 billion sale of a 23.6% stake in Telefonica – had a characteristic Peruvian twist. The biggest block was reserved for international buyers, while smaller parts were set aside for Peruvian individual and institutional investors. jp Morgan and Merrill Lynch, managers of the international portion, found the deal wildly oversubscribed and persuaded the government to increase their allocation from roughly 71% to 81%. The president’s decision to favour foreign investors – dubbed Fujigaffe in Peru – stirred up a storm of protest. Fujimori tried to recover by making an additional $135 million in Telefonica stock available to Peruvians.

The Telefonica episode convinced some locals that the deck was stacked against them. All the same, some quarter-million Peruvians bought shares in the offering, most of them people who had never before owned stock. Despite the clumsy handling, the Telefonica deal’s overall effect was to introduce stock ownership to thousands of new investors. That in itself was an important step in moving the market forward.
Sam Zuckerman

SAUDI ARABIA

Khalid makes his comeback

Sheikh Khalid bin Mahfouz is back in the driver’s seat at Saudi Arabia’s National Commercial Bank (ncb), four years after stepping down amid allegations of involvement in one of the century’s biggest banking scandals. His return has set tongues wagging in the Gulf, where it is widely assumed that the Saudi royal family prevailed upon local banking authorities to let him back in. But foreign regulators may not be as forgiving; ncb was forced to close its branches in London and New York as a result of the scandal and the family paid more than $400 million to settle charges of wrongdoing.

More immediately, bankers wonder what effect Khalid’s return may have on ncb’s performance. When he was last in charge, the bank sustained huge loan losses that almost crippled it. Since 1992 it has been recovering steadily under the low-key stewardship of Khalid’s younger brother, Mohammed. In the first half of this year, ncb reported net profits of about $120 million, 30% up on last year’s results on an annualized basis. “It’s almost impossible to say what may happen,” says one analyst.

ncb is the oldest bank in Saudi Arabia and its assets of over $20 billion make it one of the largest privately-owned banks in the world. It was founded by Salim bin Mahfouz, an illiterate Yemeni who moved to Jeddah during World War ii and made his name as a successful money-changer there, under the patronage of the Kaaki family. Together, Mahfouz and the Kaakis won permission to establish the kingdom’s first locally owned commercial bank in 1953. Since then ncb has dominated the Saudi banking system, mainly because of its government connections, nationwide branch network, close ties with leading merchants and reputation as the royal family’s bank.

As the most able and ambitious of Salim’s sons, Khalid assumed effective management control of ncb during the 1980s. But he had first caught the attention of the western media a few years earlier, when he was identified as one of a group of wealthy Saudis who helped finance a disastrous attempt by the Hunt brothers of Texas to corner the silver market.

One analyst recalls that he was “a very dynamic, gung-ho trader” who enjoyed the rush of commodity trading. Even when he was the bank’s chief operating officer, he “wanted to call the shots and make the decisions himself”, another observer says, citing reports that Khalid would get tips on possible market movements and order the bank’s chief dealer to take positions. When oil prices plummeted in the mid-1980s, however, ncb was suddenly confronted with huge amounts of bad loans, many of them reportedly to princes. After 1986, the bank reported losses or zero net profits for five straight years, sacrificed market share and was only saved from collapse by a massive recapitalization in 1992.

But it was Khalid’s entanglement with Bank of Credit and Commerce International (bcci) that proved most damaging to his reputation. Between 1986 and 1990, the Mahfouz family owned 20% of bcci and Khalid served as a bcci director. The family acquired most of its shares from a Saudi entrepreneur called Ghaith Pharaon (who had played a prominent role in an earlier attempt to corner the silver market) and it was bought out by the ruler of Abu Dhabi. The family also placed deposits with bcci and received loans from it. Investigators later charged that these share transfers and loans were questionable transactions designed in part to hide bcci’s desperate financial condition and to defraud depositors. In addition, a us Senate committee report claimed that ncb had an “intimate” relationship with bcci; for example, it alleged, bcci concealed loans to major customers of more than $500 million by “parking” them with ncb.

bcci was shut down in mid-1991 by regulators who had concluded that it was little more than a gigantic criminal enterprise. Along with numerous others, Khalid was indicted for fraud by a us grand jury and charged with breaches of banking regulations by the us Federal Reserve. However, all the charges were dropped in late 1993 when he agreed to pay $225 million to the us authorities, including a fine of $37 million. ncb also paid $245 million to bcci liquidators in Luxembourg to settle claims there. Throughout, Khalid has denied the allegations and maintained that his family was among the biggest victims of the bcci fraud. However, he stepped down as ncb’s chief executive in mid-1992, reportedly suffering from the effects of diabetes, a heart attack and a car accident.

His brother Mohammed took over day-to-day management of ncb. Although not a banker by training, he proved to be a “a good listener” and “put quite a formidable team together”, says one observer. He also adopted a leaner management structure and a more democratic approach to decision-making. “In some ways, he went to the other extreme; there were so many committees, it was almost counterproductive,” this observer says. The change in style was accompanied by a steady recovery in earning power, although ncb still carries a relatively high level of non-performing loans.

For several years, there have been internal family debates about how best to manage the bank and what to do about the Kaaki family’s shrinking minority interest. It appears that these discussions took on additional urgency when the founder died in late 1994 and they have evidently been resolved in favour of Khalid, who now seems to own all the shares, alone or with his wife. His return to active management – some observers think he has been consulted on major issues all along – must have had the approval of the Saudi Arabian Monetary Agency (Sama) and the Saudi finance ministry. But royal pressure may have been applied to extract their approval, as it has been in the past when matters of importance to the king have been under consideration.

Without going into detail, ncb’s statement announcing Khalid’s appointment as the new general manager and chairman says that, after Salim’s death, “the family agreed to transfer their interests in the bank” to Khalid and that “these arrangements have now been finalized”. Mohammed had served as chairman “whilst the ownership and other issues were being resolved”, it says, adding that Khalid plans no change in strategic direction “as the bank moves progressively towards public ownership”. It is believed that Sama has long been exerting pressure on the bank to go public, so far without success.

Some observers think Khalid’s main goal is to clear his name once and for all and to prove to the world that he is a good banker; he has retained Laurence Tribe, a professor of constitutional law at Harvard University law school, to argue his case in the us. Some think he just wants his bank back, which could mean that some of the recent management changes could be reversed. Others are more sanguine. “If Khalid sticks to his predecessor’s policies, I think everything will be ok,” says Andrew Beikos, a bank analyst with Capital Intelligence.
Norman Peagam

RUSSIA

The true meaning of veksels

If you want to know which Russian bank or company will go bust next, watch the veksel market. The discounts in promissory notes or veksels (from the German wechsel meaning exchange), issued by Russian enterprises often gives an indication of which ones are in trouble.

Originally a haven for speculators, the market has grown to about $1.85 billion and pricing has become accurate enough for some investors to treat it as an informal credit rating system. Careful analysis shows that there are many good buys to be had as well as bad ones. While foreign holdings are currently meagre, the market’s development may lead to increased holdings of this quasi-corporate debt as a temporary substitute to eagerly-awaited commercial paper issues.

According to Natalia Galenko, head of securities at leading Russian bank Menatep, there are about rb10 trillion of bills in circulation. Maturities range from three days to 18 months, are sold at the site of the issuer and then traded on exchange markets. They represent a credit chain, which should, in theory, net out. In practice, it is more like a junk bond market for corporate debt – the appearance of a bank note at a substantial discount usually represents an insolvent enterprise behind it.

Yields range from 25%-70%; non-bank issuers trade at discounts of 30% or more, and bills issued by banks which are known to be experiencing difficulties trade in excess of 50% below their nominal value.

Banks spread their risk to the market by holding a portfolio of veksels, and also use them for speculation. “It is a typically Russian solution: unplanned, spontaneous and which has developed into an informal credit rating system,” says Christopher Granville, head of research at Moscow-based United City Bank.

But like other spontaneous markets, the veksel market can easily run into difficulties. Creditors are now negotiating repayments on rb300 billion of veksels issued by Tversuniversal bank, which went bust in July.

Granville points to another function of the notes: they act as surrogate money. This has led many analysts to believe that Russian inflation would be much higher if veksels, barter exchanges and arrears were monetized. Granville, however, thinks that some of the wilder claims of this theory are exaggerated.

Menatep’s Galenko points out that foreign participation in the market is insignificant at present, although there are no restrictions on foreign involvement. Yields are lower than on gkos because they are subject to reserve requirements, but they offer a way for foreign investors to buy quasi-corporate debt, as an alternative to waiting for commercial paper issues.

Commercial paper programmes for internationally-known companies should get going next year, according to Miles Protter, executive director for liability marketing at sbc Warburg. This is all part of the evolution of a comprehensive debt market for Russia, both domestically and internationally, with other key developments being on-going reform of the gko market and gathering momentum for the issue of Russia’s inaugural Eurobond, which might lead corporates to look to foreign capital.

Western investment banks are jostling for the prize of leading the first commercial paper programme. Protter says that in six months time there may be as many as a dozen issues, with an average size of $150 million. And they will be the genuine article, each credit subject to proper disclosure and due diligence, and settling through Euroclear and Cedel. Possible names, include Lukoil, Mosenergo, Yukoil and Chevnogorneft, mainly because most already have an international profile through American Depository Receipt issues.

In addition, says Protter, a commercial paper programme will enhance name recognition to bond investors, which will ultimately prepare the ground for longer-dated debt issues. What is bubbling up in the veksel and commercial paper markets today could be hitting the Eurobond market tomorrow.
Rupert Gordon-Walker