Flights to Kazakhstan, Uzbekistan, Moldova, and Kyrgyzstan used to be sparsely filled by mining engineers or backpacking tourists. Since the start of this year, the passengers have been just as likely to include hedge fund analysts in red braces checking out what they have identified as the next hot opportunity in emerging markets.
Their attention has shifted from eastern Europe, where fixed-income yields have been narrowing across almost all the region’s debt markets. Even Russian GKOs, one of the world’s best-kept secrets last year when their yields topped 200%, now pay under 20% in rouble terms. Dollar-hedged GKO structured products – which take care of currency, custody, clearing and foreign ownership restrictions all in one – are barely showing a double-digit yield. Bulgarian T-bills and zunk bonds, the best performers in the emerging-market universe in the second quarter of 1997, are now so over-priced that some speculators have begun to short-sell them. So the party is moving on to countries that would send most traders searching for a post-Soviet atlas.
A strong indication of the trend came in June, when Hong Kong-based Regent Pacific, which has a record of digging up hidden lucrative investments ahead of the pack, successfully launched a $70 million Central Asia Fund. The first of its kind, this is spreading its net to Mongolia, Transcaucasia and the Irkutsk region of Russia in addition to the central Asian republics. Here are some of the countries where investors have found the most lucrative investments.
Kazakhstan
Almaty, the capital, has been the first stop for speculators to pick up mekams, the Kazakh local-currency T-bills. Mekams are discounted zero-coupon bonds redeemable at par and maturing after 91, 182, or 364 days. In June and August a two-year T-bill was issued for the first time.
Mekams are issued by the finance ministry and traded through the National Bank of Kazakhstan, which also acts as custodian. The bonds are dematerialized in a registered, screen-based form and are not physical certificates. There is no capital gains tax and profits can be fully repatriated by foreign, non-resident investors. This absence of foreign ownership restrictions compares favourably with the early days of the Russian GKO market, which was so wrapped in ownership and repatriation controls that initially it was accessible only to well-connected niche players. The one restriction for Kazakh mekams is that the finance ministry limits foreign purchases to 25% to 30% of the entire lot in each auction.
After each auction, all mekams are kept in deposit accounts opened by the primary dealers at the National Bank. Primary auctions for 91-day mekams are held each Tuesday; 182-day mekams are auctioned on the first and third Thursday of each month and 364-day bills are re-auctioned once a month, usually in the third week. In total, seven auctions are held each month. To date, approximately $750 million of three-, six- and 12-month mekams have been issued and about $200 million are outstanding.
During 1996, annualized yields in US dollars averaged 25.5% for six-month mekams and 22% for three-month bills. Twelve-month bills have averaged a 38.6% yield in local currency terms. It is possible to hedge against depreciation in the tenge, the local currency, through the Kazakh Currency Exchange where foreign-exchange futures are traded on a margined basis. The exchange began trading in April 1996, volumes are still low and there remains a less-than-Chicago-Board-of-Trade certainty of risk-free settlement.
At the macroeconomic level, Kazakhstan holds the same credit rating as Russia. Gross national debt of $3.77 billion in 1996 was 18.26% of GDP. In November last year, Standard & Poor’s, Moody’s and IBCA assigned a BB minus rating for long-term foreign currency debt and S&P additionally assigned a BB plus for long-term local currency debt.
So much foreign capital has flooded into the Kazakh fixed-income markets in recent months that prices may have hit their peak. The spread to US treasuries on the sovereign Eurobond fell to 200 basis points in August after exceeding 300 last January. Three-month mekam, starting 1997 at a 26% yield, recently yielded 12.2% after falling to 10.3% in June. Deutsche Morgan Grenfell (DMG) predicts the mekam annual yield will fall to 10% over the next 12 months. The tenge started 1997 at 73.6 to the dollar and, although in steady depreciation during the first half, it has stabilized in recent months and recently was trading at 78.
“We see foreign investors starting to back out when the three-month bills hit the 13% level,” explains Michiel de Bruijin, general manager in Almaty of ABN Amro, one of the top three primary mekam dealers. “Expectations on the tenge remain strong. The only concern is the resolution of the pension issue – the government has pledged to pay off all of its pension arrears and that has created some uncertainty about inflation which may limit any further price increases. Nonetheless, we still expect prices to remain at this level and possibly go a bit higher.”
Uzbekistan
The nation is still emerging from the recession which hit all former Soviet republics after independence but recently the economy has accelerated, and the government forecasts 5% GDP growth in 1997.
Uzbekistan is beginning to develop a fixed-income market after the introduction last year of som-denominated three- and six-month T-bills trading at a local-currency yield of 40%. The country has neither credit rating nor any outstanding Eurobonds though the government is holding preliminary discussions with S&P and investment banks. A sovereign Eurobond issue could be issued in 1998.
In early 1996 the Central Bank of Uzbekistan began a monthly auction of three- and six- month bills. Outside the primary auction, where total sales could be anywhere from $500,000 to $6 million, there is a secondary auction four times per week. In July, $165 million in T-bills was outstanding; rates were 25% on the three-month and 26% on the six-month bills.
The bills are dematerialized and exist only on the register of the Central Bank. There is no continuous pricing nor screen-based system of monitoring the market. However, as there are few market participants, precise two-way prices are easily obtained by telephoning around during the four weekly secondary auctions, which last about an hour each. There have been no reports of difficulties in registration, custody and settlement of trades.
At present the government permits only domestic investors in the market. While most buyers are 100%-Uzbeki entities there have been several Uzbeki-foreign joint ventures involved. Out of approximately 20 institutions which act as primary dealers in the auctions, 16 are Uzbeki commercial banks, and four are Uzbeki-foreign joint ventures. One of the most active dealers is ABN Amro, which trades as an Uzbeki-Dutch venture. Holdings in ABN Amro in Tashkent are divided between ABN Amro (50%), the Uzbeki National Bank for Foreign Economic Relations (30%) and the IFC and EBRD (10% each).
A second barrier is presented by strict currency controls. Uzbekistan is one of the few former Soviet republics with two currency markets – one gives an official Central Bank commercial rate, the other a black-market rate, reflected by sidewalk kiosk prices which change slightly from week to week. A year ago, the black market rate was Som80 to the dollar against the official rate of 50. This year it fell to Som160, while late last month it was at 142 against the official rate of 72. Since there are no clear-cut methods to exchange soms into dollars for repatriation abroad and uncertainty surrounds the entire exchange-rate mechanism, foreign fund managers have been put off even attempting to enter the market.
The official exchange rate is kept stable by severely limiting the number of importers permitted to obtain hard currency to purchase goods. This Soviet-style system punishes exporters, which must surrender their earnings in return for soms converted at an artificially low rate. At the other extreme, well-connected importers, which can purchase dollars cheaply, make a killing by importing and selling their goods at a free-market som rate.
The IMF has demanded unification of the exchange rate as part of a programme designed to make the som freely convertible. It would cost the Central Bank over $100 million fully to eliminate currency controls and implement one free-market rate. Analysts’ forecasts put the official exchange rate in 1998 at Som90 to the dollar. Monthly inflation is estimated to average 32% next year.
“We do get calls occasionally from foreign investors expressing an interest in the market but as soon as we explain the currency controls and ownership restrictions, they draw their own conclusions,” says Peter Klein, general manager of the ABN Amro office in Tashkent. “So far, there is no way around the regulations through swaps or structured products. But there have been discussions with the government about opening up the T-bills to foreign investors sometime in the future.”
Kyrgyzstan
Starting off as one of the least economically developed regions in the CIS, Kyrgyzstan nevertheless has managed to maintain positive economic growth since independence. Last year’s 5.6% increase in GDP is expected to reach 7% by the end of this year. The government has implemented one of the fastest privatization programmes in central Asia. Relations between Bishkek, the Kyrgyz capital, and China, are even better than between China and Russia.
These are impressive accomplishments given that 94% of the country is mountainous, 75% remains under permanent snow and ice and nearly half the population lives under the poverty line with an unemployment rate of 20%.
To the surprise of even Moscow-based fixed-income investors, there has been in Bishkek a small but thriving local T-bill market since 1993. The finance ministry issues two types of short-term som-denominated instruments: GKVs and, less commonly, GKOs. The latter are issued sporadically by the ministry whenever the need for short-term financing arises. GKV auctions, by contrast, are held regularly each Thursday morning by the National Bank of Kyrgyzstan with the amounts available for purchase known well in advance. On average, there are 10 to 15 primary dealers which participate in the weekly auctions, although a far greater number of participants, including small firms and private individuals, take part in the secondary market, which is held in the Kyrgyzstan Stock Exchange. The finance ministry recently announced plans to step up GKV sales to reach 15% of the value of GDP.
Three different GKVs are issued: three-, six- and 12-month. At an auction in late August, three-month GKVs yielded 28.7%, six-month paid 39.31% and the 12-month yielded 33.7%. Total volume for this one auction for all GKVs was just over $1 million. The total size of the entire T-bill market, both GKVs and GKOs, is nearly $200 million.
Much like the T-bill auctions in Tashkent and Almaty, prices at each primary auction are very much influenced by the liquidity available on the day. If only eight dealers participate, then prices may be low and yields high. On the other hand, the following week there may be 15 dealers, some with a short-term cash surplus available for investment, and thus prices will be higher. For most of 1997, prices have climbed steadily. In January, yields on three-month GKVs hovered around 50%.
GKVs, like Russian GKOs, are dematerialized and exist on a computer register with the National Bank of Kyrgyzstan. However, if a primary dealer purchases a GKV on behalf of a client, although the dealer’s name is registered, that dealer must give a paper certificate to the client. Legal title is vested in the name on this certificate. Should the dealer collapse then the client’s ownership of the GKV should not, in law, be affected.
There are virtually no currency controls in Kyrgyzstan other than a steep 2% commission charged by most banks for currency transactions. Hard-currency profits can be repatriated freely. However, the Bishkek currency market is characterized by thin trading volumes. In a good week, total volume traded for five days rarely exceeds $10 million. This volume not only includes funds coming out of the T-bill market but also reflects virtually all major currency transactions in the country.
Much as in Bulgaria, Romania and Poland in their early days with a free-market currency, the lifting of all regulations has not fully eliminated the complications involved in moving significant amounts of funds in and out of the country. If there are too few dollars available for purchase in Kyrgyzstan, a foreign investor may find himself sitting on a pile of soms waiting for the market to pick up again. The som has proved to be one of the most stable currencies in the CIS, starting the year at 17.95 per dollar and today trading at 17.21. Early last year, it averaged about 16 to the dollar.
According to Autandil Adykulov, head of securities at Maksat Bank, one of the primary GKV dealers in Bishkek: “There have been a number of foreign buyers from Europe, the US and Asia. Repatriation of proceeds is usually not a problem since most banks are members
of Swift. The only issue is liquidity in the markets. The currency market is small, so it could take some days to convert a large amount of soms and the GKV market itself can fluctuate substantially depending on the number of dealers taking part in the auction.”
Moldova
An active T-bill market has been in operation in Chisinau since mid-March 1996. There are five maturities: 28, 91, 182, 273 and 364 days. An auction for the benchmark 91-day bills is held every Tuesday with settlement every Thursday, giving an investor two days to decide to settle or roll over his position. The last auction raised a total of $10 million with $4 million-worth of three-month bills sold.
The dematerialized T-bills are registered in a book-entry system run by the National Bank of Moldova with 18 primary dealers officially licensed to take part in auctions. Although there is a secondary market, a 0.3% transaction tax on securities trading has limited secondary market activity. New legislation expected to be implemented in December 1997 would abolish this tax.
According to Fred Havel, a Chisinau-based US treasury official advising the Moldovan finance ministry: “The government is in negotiations to develop the market so that they could extend their average maturity and at the same time create one particular benchmark instrument that would attract foreign investment.” Havel notes that: “The primary-dealer banks here are by and large not world-class triple-A custodians. If the bank fails, it is not clear how clients would recover their funds invested in the T-bills. A foreign fund would certainly want to look at the credit of the custodian bank.”
A third debt instrument, the “special destination bond” was issued at the end of 1996, raising just under $10 million which was earmarked for a social insurance fund benefiting pensioners. The bonds yield roughly 20%.
The yield for three-month T-bills hit a high of 111% during the initial weeks of trading. However, for most of 1996, yields averaged 50% and this year the bills are averaging a 35% yield. Recently, after the wide publicity and investor interested generated by Moldova’s debut Eurobond issue, yields have fallen to just under 19%. Stability of the Moldovan lei, which has remained at 4.48 to the dollar, as well as tight control of the money supply have also increased confidence in the market. The total value of all outstanding T-bills is about $100 million. Restrictions on foreign purchases were lifted at the end of last year. Since then, with a freely convertible lei eliminating difficulties of repatriating proceeds, about 35% to 40% of bills in circulation are now held by foreign investors. Merrill Lynch, through its London office, has managed a number of small private placements of these bills.
DMG’s Gerhard Krause, one of the few banking economists to analyze Moldovan capital markets, says he thinks the recent rally in prices may be at an end. “Although the lei has remained stable up to now, we think there will be some definite inflationary pressure before the end of the year, causing the currency to depreciate. The privatization programme is not going as quickly as the government thought so there will probably be a shortfall in the current account. The investors who were lucky enough to have entered the market at the start of the year are taking their profits and may start to leave.”
Next stop equities
The flight of hot-money speculators away from Russian GKOs to the ex-Soviet republics during the first half of the year has been startling. Perhaps the main reason for their enthusiasm is that most of the investors in CIS T-bills were active participants in the Russian GKO market. All the gloomy predictions about how Russian T-bills were elaborate pyramid schemes, or how a dematerialized registration system was bound to cause problems, proved unfounded. Since the sharp rally in CIS T-bill markets reached a peak, the next search may concentrate on equities.
“Our newly launched Central Asian Fund will be investing to some extent in T-bills but we think we can really make money for our clients in equities,” says Julian Mayo, Regent Pacific’s head of research. “There are liquidity problems in all the markets we are targeting but we have already started actively buying in many of them.”
