The Czech koruna bond market has been heralded as the model for the emerging capital markets of central and eastern Europe. The Czech Republic has what appears to be a stable economy, the currency is riding high, and the international financial community has tipped it as the first country in the region to join the European Union. Debt issuance is accelerating to keep up with investors partly spurred by high nominal interest rates.
Last September, the market’s prodigy, the Eurokoruna, was born. A new-year flurry of koruna-denominated Eurobonds seemed only to underline the market’s position in the first few weeks of 1997, 17 were issued with a total value of Kr26.5 billion ($968 million) compared with issues worth Kr32.6 billion in the whole of 1996. Market estimates are already beginning to suggest a total of between Kr100 billion and Kr130 billion for 1997. However, the Czech Republic’s reign as sovereign of the region’s emerging markets may be short-lived and analysts are beginning once again to doubt its economic health.
“The Czech Republic has lost some of the promise that made it one of eastern Europe’s most attractive currencies in the last few years,” says Gabor Bognar, economist for eastern Europe at Goldman Sachs. A recent investor report by the investment bank said that developments in the fiscal and financial sectors warranted “a more conservative view toward the market”.
“We note in particular a deterioration in trade performance and composition of capital flows, an easing of monetary policy, a weakening of the banking system and an increase in political risk,” says Bognar.
Yield hunger unsated
Despite this, European retail investors have snatched up this year’s issues, attracted by double-digit coupons and not deterred by the Czech National Bank’s (CNB’s) repeated efforts to cool the koruna. It has risen 4% against the Deutschmark since the start of the year. Eurobonds can be easily bought and cleared, which makes them attractive for yield-hungry investors, unlike eastern European domestic bonds which are accessible only to professional market participants. The bulk of investor demand is for short-dated products. The inverted yield curve between one and five years in Czech koruna bonds means that on a relative-value basis the short end has been the most attractive to investors.
Like the rand, the koruna has become popular because of the conjuncture of bullish expectations on the currency, which have attracted investors, and highly advantageous swap rates for issuers. “More and more banks are trying to manage the issues to cash in on the demand there,” says Bern Kuehl, a trader at WoodCommerz in Prague. “Looking back to last year there were only a few banks issuing. The supranational-issued bonds signified that there was definitely hope for the economy and this opened the door for others.”
“The explosion of issues has come on the back of the current perception of eastern Europe as a hot market, but now the risk-reward ratio is significantly less attractive,” says Martin Taylor, senior investment manager for European emerging markets at Baring Asset Management.
Swap opportunities continue to attract issuers. Most of the issuance still tends to be arbitrage-driven but conditions are tightening. “It all depends on the level of the Czech swap curve,” says Kay Haigh, senior economist at Deutsche Morgan Grenfell. “Issuers need a swap curve of 10.5% to 11%. As long as the swap curve continues, issuers will maintain interest.”
Already the market has undergone much diversification. Issuers are quickly learning that they will have to innovate if they are to continue attracting overseas investors. Last year the Kr2 billion 11.50% one-year issue for the World Bank led by ING Baring broke new ground in the sector by employing a global structure for the first time. By harnessing the combined clearing and settlement capabilities of Cedel, Euroclear and DTC, the deal targeted the US institutional base, which had previously only been able to buy Eurokoruna bonds after a seasoning period. The issue sold out within a few hours of the launch something previously unheard of in the sector and seemed to justify the issuer’s and the lead manager’s attempt to tap a largely unexploited investor base.
The diversification process continued into 1997 with corporates such as General Electrical Capital and Volkswagen Financial Services joining supranationals attracted by arbitrage opportunities and the ability to use their existing bond documentation such as Euro-medium-term note programmes. “[The VW issue] was entirely a swap-driven transaction,” says Alex Oelrich, manager of Volkswagen Financial Services. “We were not looking for Czech koruna but were able to use an existing EMTN programme.”
Goodbye to all that
But the favourable conditions are increasingly looking like a thing of the past. “Since the beginning of the year, swap opportunities have been less positive,” says DMG’s Haigh. “The swaps are still available but the deals are not so good. We can expect to see a slowdown in Czech funding.”
General concerns about the Czech market are more or less the same as they were a year ago: the slow pace of corporate restructuring, lack of sufficient market regulation and a widening trade deficit. At the same time there is a feeling that sooner or later the government will have to address at least some of these problems. Specifically, the strength of the currency is a worry following reports that devaluation was imminent. With a trade deficit of $5.8 billion in 1996 (the biggest in central Europe at nearly 7% of GNP), a current account deficit, a slowdown in growth and high interest rates supporting the koruna, many observers are arguing that the Czech government’s current path is unsustainable.
Pessimists, including those at Goldman Sachs, worry that if the deficit continues to widen, the government may be forced to take drastic action, including devaluation, to make Czech exports more attractive. “No-one knows what the figure will be for the trade deficit but everyone is wondering how long it can keep growing without having an impact on the currency,” says Jan Klernor, head of fixed income at Patria Finance in Prague. “But if the figures get any worse investors will withdraw from the Czech Republic. Bad figures could destroy everything.”
The CNB’s on the line
There are also doubts about the Czech government’s policy goals, including perhaps the Czech central bank itself. “These days the CNB are on the phone to us every day checking the value of the koruna,” says Klernor. “The chairman of the CNB said that the koruna will remain free inside the parity, but it’s likely that they will be forced to devalue.”
The Czech bond market could be a victim of its own success. The strong demand for the koruna amid the flood of issues could be the very thing that stalls the vaunted flagship economy. “Now the currency is so strong due to all the money flowing in. The currency has appreciated way above an already widened parity,” says WoodCommerz’s Kuehl. “The risk of devaluation is certainly much higher than it was two to three months ago because of it.” The central bank has certainly given fair warning of some sort of action. At the end of January central bank senior director Jiri Pospisil said there was “no rational reason for the [koruna] to be so high”. Towards the end of last month he hinted that key interest rates might be lowered to bring the currency down.
Investors will also need to become more sophisticated to reflect the riskier climate. The Czech bond market is not as investor-friendly as it was. “This used to be a no-brainer market,” says George Collins, a portfolio manager at Patria Asset Management. “But now it’s becoming increasingly tricky. Investors now must really do their homework.” Since most of the issuers of Eurokoruna bonds have been triple-A rated, the demand has been dominated by continental European retail accounts, especially in the Deutschmark bloc, looking to exploit the interest rate differential between Czech and German rates to achieve high-yield returns while taking on currency risk in an investment-grade country.
“The Czech bond investor is typically a retail investor. These tend to be from the less sophisticated end of the spectrum,” says Haigh. “They could get a better deal if they tried. The coupons are, however, high for Europe and up until now the risk has been low.”
Many argue that returns on Czech koruna bonds no longer reflect the increased risk. “The Eurokoruna might make sense for the issuers who can take advantage of the attractive arbitrage opportunities to get sub-Libor funding,” says a London-based fund manager, “and it might make sense for the banks who are getting paid for negotiating the swaps. But I can’t see why it would make sense for the professional investor. The coupons don’t reflect the country and foreign exchange risk. What seems to be happening is that unsophisticated continental retail investors are really just subsidizing the issuers and the lead managers for the privilege of dabbling in the Czech economy. The investors don’t really know what’s going on.”
“The bonds have been sold to those who unfortunately are often not up-to-date with the challenges facing the Czech Republic’s economy,” says Goldman Sachs’s Bognar. “They are told of increasing yields and are pointed to relatively stable koruna rates over time. One only hopes for them that the economic and political conflict is resolved before the bonds mature. But it is not a government well-placed to deal with the macroeconomic problems. It is more focused on day-to-day survival.”
Rivals for funds
The consensus-seeking nature of Czech politics has brought an enviable degree of stability but the government is weakening. Having effectively lost its cabinet majority, the Civic Democratic Party of prime minister Vaclav Klaus must now listen to its newly assertive partners, the Christian Democratic Union and the Civic Democratic Alliance. In 1997 the coalition will be tested again, this time from within. It will become crucial for the coalition partners to pull together, as a number of urgent tasks can no longer be delayed.
Last year there were maiden Eurobond issues for many eastern European borrowers, including Croatia, Kazakhstan, Russia and Slovenia, and more firsts are expected this year from borrowers such as Ukraine and the cities of Moscow and St Petersburg. The Slovak koruna is also pegged to the Deutschmark/dollar basket and could easily provide an alternative to investors. So far only a handful of Slovak koruna bonds have been launched, but if issuance increases, buying could be drawn away from the Czech market.
“1997 will be the year of eastern Europe,” says DMG’s Haigh. “Everyone is jumping on the bandwagon.”
