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The Spanish treasury has unveiled a plan to revamp the country’s capital markets in an attempt to attract new investors and cut the cost of borrowing. The scheme involves modernizing the municipal bond market and is one of a series of reforms designed to increase Spain’s chances of joining the first wave of European monetary union. “We are considering the introduction of floating-rate notes,” says treasury director general Jaime Caruana. “We started issuing short-term six-month letras (T-bills) in September and investors now have an auction calendar that reflects market demand on a regular basis. Plans for strips are in an advanced stage although we first have to tackle some of the tax matters involved.” Henrik Lumholdt, chief economist at Bank of America in Madrid, believes that strips will be the first new product to be launched and this will probably be the most beneficial of the planned changes. “They will add liquidity and enable investors to match their requirements more reliably. They will also help to arbitrage the market,” he says. There have already been several piecemeal reforms to the Spanish market over the past five years which have helped improve efficiency. “We [now] have a book-entry system run by the Bank of Spain and the treasury operates regular weekly auctions of short-term T-bills and medium to long-term [three to 15-year] bonds on a monthly basis,” says Enrique Pérez Hernández, deputy director general of Banco Central Hispano (BCH). “The system works well and 48 hours prior to each auction the treasury negotiates with market-makers the minimum and maximum amounts it is prepared to allocate. This gives a reference to the market.” But there have been failures as well. In 1994 the treasury experimented with 15-year bond issues, most of which were bought by a few savings banks. These bonds are now illiquid. Lumholdt says the treasury was chastened by that experience and thinks it will delay launching its first floating-rate note until it has guaged the success of strip issues. “There is some hesitancy to come out with too many new instruments at once which might prove to be illiquid, especially after the failure of the 15-year segment,” he says. Liquidity is a key issue for traders both in the cash market and in Mercado de Futuros Financieros (Meff), the Barcelona-based fixed income futures exchange. Analysts say that unreliable liquidity in the cash market means that the bulk of futures trading is linked to 10-year securities. The very efficiency of Meff has drained liquidity from the cash market, a feature that the government hopes to rectify in its drive to cut borrowing costs. Record volumes Meff set a record in trading volumes in October with a 14.7% rise over September, itself a record month for the exchange. A total of 2.8 million contracts was traded in October, representing a nominal value of Pta42.8 trillion ($329 billion). The sharp decline in government bond yields in the past six months, market expectations of a further cut in interest rates and the narrowing of the Spain-Germany yield spread have fuelled the surge in trading volumes. The 10-year bond contract continues to dominate trading with monthly turnover of 2.3 million futures and 292,000 options contracts. Last June Meff launched its new Diff contracts on French, German and Italian government bonds based on the price differentials between long-term interest-rate futures contracts. This brought new liquidity to the Spanish market by allowing investors to execute a variety of strategies inexpensively and with a wide variety of trading, arbitrage and hedging possibilities without having to enter into positions in different markets. The treasury’s plan to reform the debt market extend beyond the pure public sector. Caruana says the government is considering amending the law on securitization, which was introduced in 1992. It created ideal conditions for the issuance of bonds backed by residential mortgages, but is regarded as too restrictive. But one of the largest securitization deals was a one-off transaction involving the power sector. The government last year froze its nuclear power programme and a $6 billion scheme was organized in which the leading utilities placed bonds to get rid of their nuclear debt. This and a $2 billion issue by the banks when the law was passed have been the only two large securitization deals. The new law will make enable banks to structure a wider range of deals. “The ability to securitize non-mortgage-backed assets will be very helpful,” says Javier Alarcé, head of capital markets and treasury at Spanish bank Argentaria. “This has been in the works since 1994 but given the problem of tax implications and with the recent change in government it has so far failed to materialize. It would be quite a useful instrument to have available to enable companies to get rid of some of their unwanted assets.” The fastest growing sector of the Spanish capital markets has been regional debt. Outstandings rocketed from Pta945 billion in 1991 to Pta4.2 trillion in the first half of 1996. Analysts expect the growth to continue because the central government accompanied the 1997 budget with a law giving the regions more freedom on expenditure and revenues, thereby increasing their ability to raise debt. The move toward fiscal federalism has placed heavier demands on the coffers of the regional governments and this has prompted a sharp rise in issuance. “Regional debt is not 100% like central government bonds but it is quite close and offers high yields,” says Manual Navarro, a dealer at the Caja de Madrid savings bank. A shift to the regions Some 14 out of 17 “autonomous communities” have already tapped the bond market and now account for 75% of outstanding semi-public debt. They pay a spread against government debt that can range from 10 basis points in the case of the Basque government to 70bp for a high-risk issuer such as the government of Murcia. Foreign investors often find the secondary market cheaper for these issues than public auctions since banks bid up the price of paper in a highly competitive environment. Valencia, which operates a system of monthly public auctions, is funding its debt at one of the cheapest rates. It normally offers a spread of some 15bp over 10-year bonds while Catalonia has been paying 20bp to 25bp. Prime minister José María Aznar’s centre-right government, which came to power last May and depends for a parliamentary majority on its regional allies, is set to enact a law that will shift up to 30% of income tax revenue directly to the regions within the next two years. “With the new system we are likely to see an improvement in the state of local finances,” says Juan José García, director at Standard & Poor’s in Madrid. The social cost implicit with the EU’s economic and monetary union will be minimal compared with the potential political cost of securing support for the government’s rigid 1997 budget. The Catalans and other key regional parties are aware that the government is determined to meet the Maastricht criteria for Emu membership at all costs and they will be pressing for more fiscal autonomy for their regions, which in the longer term could create problems with a multi-tier taxation system. But the treasury’s Caruana indicates that there will be no compromise on Emu. “We will do whatever we have to do on the fiscal front,” he says. “We would have to do it with or without Maastricht.” Domestic investors move in Other issuers in the domestic market are Spanish state holdings and several corporations, whose presence has been practically nil given their healthy balance sheets. Some have raised loans from banks on a floating-rate basis priced on the Madrid interbank offered rate (Mibor), assuming that Spanish rates were tracking downward. Foreign investors now play a much smaller role in the Spanish debt market than they did in the early 1990s. Their holdings were less than 30% of total outstandings in the boom last year, compared with 50% of outstanding in the bull market of 1993. Their holdings now are about 25%, which is still relatively high after a dramatic pull-out by foreign investors in the 1992-94 period of peseta turmoil. “We have seen this go from a foreign investor-led to a domestic investor-led market in a period of six months,” says César Molinas, chief economist at Merrill Lynch in Madrid. “Domestic players are much more willing to buy because they are fully convinced that Spain will be among the first-tier countries to join Emu in 1999. So, as far as bonds are concerned, we are looking at a 10-year gold mine given the outlook for falling interest rates.” The Spanish bond market remained relatively unaffected by foreign influences for most of 1996 because of significant inflows into domestic investment funds. Collective investment schemes grew to represent 24% of GDP last year with a total of $148 billion in funds under management, up 47% over $100 billion in 1995. Merrill Lynch expects 15% growth this year, lifting the total to $170 billion. “From a situation where Spain has had almost no investment funds we now have the second-widest scheme in Europe after France,” says Molinas. Bank of America’s Lumholdt says that the historical correlation of Spanish and American 10-year bond yields disappeared when flows into Spanish investment funds accelerated. “These flows in turn created a relatively constant domestic demand for bonds which caused low volatility in the Spanish market even when expectations of a Fed rate hike were at their strongest,” he says. Lumholdt explains that the correlation betwen Spanish and German bond yields is now as strong as it was in 1993 and 1994, highlighting the fact that Spanish domestic factors have stepped into the background. “The upshot is that the risk to the Spanish bond market is primarily an international matter now.” The Aznar government’s tax changes have encouraged inflows into the fixed-income market. Juan Pérez-Campanero, a director at Banco Santander, notes that the treasury recently lowered capital-gains taxes which previously were set up to a top rate of 56%. “It is now a standard 20% for everybody on investments of two years or more. This has stimulated a shift in savings from bank deposits to the fixed-income market.” Pérez-Campanero also says that the lower relative weight of foreigners is partly explained by their shift out of cash bonds and into the futures market. “There is a greater degree of liquidity, the rollover works well and Meff offers an investor good leverage,” he says. Tax tricks Apart from regional debt, one of the fastest growing segments of the Spanish capital markets is the Matador market domestic bonds issued by foreign borrowers. There were 85 new issues totalling Pta900 trillion from January to mid November last year. Spain is one of the few countries in Europe that restricts access to its domestic currency market. “There is no Euro-peseta market,” says Miguel Salis, a director of Salomon Brothers in Madrid. “The treasury regulates entry into the Matador market and the number of issuers that can borrow in pesetas is limited. The authorities have been extremely conservative but this will change in the future.” Presently, the only borrowers permitted to launch Matadors are 17 supranationals such as the World Bank, sovereigns and public agencies in cases where there is budget support. Despite these restrictions, the Matador remains one of the most attractive bond markets in Europe for issuers and investors alike. “The great advantage is that there is no withholding tax for non-residents in this market,” says BCH’s Pérez Hernández. Spanish investors pay a 25% withholding tax; non-resident investors are entitled to reimbursement value the same day. “Reimbursement is working very efficiently and this is one of the reasons that the Spanish spread over Germany is lower than Italy’s,” says Pérez Hernández. “The Italian reimbursement system can take up to six months.” Spanish investors seeking to avoid withholding tax often transfer their bond positions to non-residents 30 days before the date of payment of the coupon. This coupon washing is widespread and the government has shown little inclination to crack down on it. Spain’s Emu prospects Pérez Hernández says matador bonds are generally issued where there is a need for pesetas to relend into Spain to finance Spanish infrastructure. “Since its appearance in 1987 the matador bond has produced many benefits for the fixed-income market,” he says. “It has generalized annual payment of coupons, as well as providing support for the development of a swap market and various new structures such as swap auctions, floors, collars and caps.” The bond market started the last phase of its 1996 rally in September amid the growing conviction that Spain will achieve economic convergence criteria and join Emu in the first round in 1999. The rally began in mid-March when 10-year bonds were yielding 10%. These dropped to 8% and in early December were down to almost 7%. The performance of the capital markets in coming months will be linked closely to the country’s perceived chances of making it into Emu and there are some doubters. Brokers are sceptical that Spain will be allowed to follow France in fudging its accounts to achieve convergence criteria. And should Italy fail to make the first round while Spain gets in, there will be the question of how to explain matters to the Italians, whose country has twice Spain’s GDP and a significantly larger industrial base. In pursuit of Emu criteria, the Spanish economy in 1997 will need to grow strongly enough to generate a fiscal deficit reduction comparable to France’s, but not so strongly that inflation will start going up again. The narrowing of the differential with Germany is perhaps the strongest sign of investor confidence that Spain is converging. After reaching a low of 155bp at the beginning of October when the 10-year yield was 7.5%, the differential fell to the 130bp to 140bp range in late November. The peseta has remained firm against the Deutschmark and is trading in a very narrow fluctuation band of around Pta84 to the Deutschmark, which in turn is favoured by the still high short-term interest-rate differential with Germany. The differential and 10-year yield are not expected to vary much in the near term as there will be no significant changes in fundamentals. The market has already discounted 3.5% inflation by the end of 1996. If Spain continues towards convergence, economists are confident that purchases of Spanish debt by foreigners seeking to take advantage of the fall in the 10-year yield gap could lift the peseta to above Pta83 to the Deutschmark and trigger a much-heralded cut in the intervention interest rate by the Bank of Spain. The government targeted a deficit for 1996 of 3.5% of GDP, although some are worried about a Pta125 billion social security deficit overshoot that could skew the picture. Given the absence of inflation, the forecast is for a reduction in the overall deficit to about 2.5% of GDP in 1997. This would enable Spain to meet the convergence criterion of 3% by the beginning of 1998. Waiting for a rate cut Bonds have been driven partly by the perception of falling inflation which also is seen as a sustainable feature. This has its roots in a relatively weak economy in which growth was expected to nudge 2% in 1996 compared with 3% in 1995. The recovery that began in 1994 was the result of a cumulative peseta devaluation of 40% in the two previous years. This stimulated export growth and investment activity but private consumption never made a significant comeback. Despite high market expectations, the Bank of Spain may prefer to wait for more durable signs of low inflation and positive budgetary performance before its next rate cut. Alternatively, it may settle on a 25bp reduction in the intervention rate instead of a widely-predicted 50bp. |
