The Bund stops here


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Can Germany's Bund become the sovereign benchmark bond in Europe after the introduction of Europe's single currency in 1999? The debt office in Bonn and the Bundesbank have both made urgent reforms, but the government continues to shirk vital decisions. And the lacklustre performance of the government suggests that borrowing targets may be missed. The consequences will be serious both for interest rates and Germany's standing in European capital markets

A phone call to Germany's debt office on Monday, February 10, went unanswered. It's Rosenmontag, at the climax of the German carnival season, and all the staff responsible for borrowing on behalf of the Federal Republic of Germany are in the streets of Bonn enjoying a Rhineland carnival parade. The nation's Dm54 billion ($32 billion) borrowing programme for 1997 is on hold until the next day.

Although few countries borrow as much on the capital markets as Germany does, few spend so little doing it. The public servants responsible for the finance ministry's cost-cutting programme may well be proud that they pay fewer than ten people to work full-time on German national borrowing. (Bankers say there are only three people who make the real decisions.) Yet they seem unaware that Germany might save tens of millions of Deutschmarks every year in borrowing costs were more time and resources spent on better management of Germany's sovereign debt.

Take Bonn's recent decision to allow stripping of interest coupons from the principal of German sovereign issues (Bunds). Sources at the Bundesbank, its fiscal agent, say they spent two years trying to persuade the finance ministry to permit this innovation. Yet the benefits are obvious. Not only does it add interest and opportunity to the Bund market, traders say it also cuts Germany's borrowing costs by around five basis points. That should save tens of millions of Deutschmarks this year alone on the current federal debt of Dm839 billion (the total public-sector debt was just over Dm2 trillion at last count in June 1996). Since Germany desperately needs to reduce its federal budget deficit in order to get somewhere near the 3% ceiling laid down in the Maastricht Treaty single-currency criteria, the finance ministry might have given the idea more urgent consideration.

No wonder the financial market says too little thought goes into Bund issuance, either by the finance ministry or the Bundesbank. Traders complain that Bunds are missing at certain maturities, they believe that the banks that underwrite Bund issues are treated unfairly and argue that the German government could borrow more cheaply if it organized its borrowing in a more disciplined manner.

More reform is essential, they say, if Germany is to achieve its ambition of becoming the sovereign benchmark issuer in Europe. The Bundesbank has now begun to issue public as well as private warnings to the finance ministry about the importance of that goal. Bundesbank vice-president Johann Wilhelm Gaddum predicted in a recent speech that a single European country would emerge as the benchmark sovereign issuer. He expected "an increasing level of competition between sovereign issuers and between the leading financial centres in Europe for the favour of international investors." Significantly, Gaddum did not trumpet Germany's chances of winning either race.

Theoretically, Germany has a good chance of remaining Europe's most important sovereign issuer. The federal republic is a huge borrower and remains by far the largest, if not the most influential or innovative, economy in Europe. The Deutschmark is Europe's main reserve currency and when that currency disappears by 2002, investors are likely to trade Bunds instead as the main indicator of German economic performance.

But as Gaddum points out: "The answer will be determined not only by the financial policies of the countries participating in monetary union... A much more central role will be played by each nation's debt management. When the currency-linked differences between various markets disappear, international investors will then favour the markets that offer them a complete selection of maturities and sufficient liquidity in each issue."

Over the past 12 months, banks in Germany have been encouraged by the fact that both the Bundesbank and the finance ministry are doing more to reform the issuance and sale of German sovereign paper. First, the authorities are asking the advice not only of banking lobbyists, but also of Bund traders. "The fact they're asking us shows they're taking it seriously... they never did so before," said a chief bond trader who was invited to express his views at a meeting called by the finance ministry.

And they have not only listened. The federal republic is the largest issuer in Europe, yet to investors' dismay it had allowed gaps to appear in its schedule of maturities, notably at the short end and the very long end. Last year the Bundesbank became so concerned at the shortage of two-year paper from the German state that it downscaled its fundamental objections to short-termism and persuaded the finance ministry to issue this paper after all. The ministry also promised to repeat issues of six-month Bubills and of two-year paper every three months. Now, urged on once again by the Bundesbank, the finance ministry has promised at least to think about resuming the issuance of 30-year debt and will possibly tap the market in the summer.

Stripping ­ an innovation that will finally be permitted at mid-year ­ will ease the problem of gaps on the Bund curve. Then the market will be able to detach interest claims on outstanding debt from the capital and trade them separately, thus creating liquidity at a wider range of maturities.

The Bundesbank now argues that investors have near-certainty (barring unforeseen volatility in the bond market) with the fixed issuing calendar in three of the main debt instruments: six-month Bubills, five-year Bobls and two-year federal treasury notes (Bundesschatzanweisungen).

As for the Bund itself, the Bundesbank has followed the French example by promising to organize just two large, liquid Bund issues every year, with fixed-coupon dates on January 4 and July 4. The recent New Year Bund, which came to market with an initial volume of Dm27 billion, eased the shortage of 10-year Bund paper. Bankers would like to see fixed dates for interim increases in current issues, too, but the finance ministry fears losing flexibility to respond to market changes if it committed itself to fixed-issue dates for Bunds too. Bankers are still not content and ask why, having started answering the demands of market participants, the ministry will not take the project to completion.

Even now, the debt office borrows only what it needs for the immediate future, rather than taking advantage of favourable market conditions by borrowing ahead of time. Nor does it market its debt particularly well by producing adequate information about its borrowing policies. Traders and investors may be receiving more in writing from the ministry, even if that amounts to no more than glossy brochures, but it would be a sign of weakness for the German government to stage a bond road show, as other major sovereign issuers in Europe do. It seems almost as if the ministry wants to keep its new approach a secret, at a time when it should be boasting to the market.

"They should introduce a calendar and make regular appearances on the market in the full range of maturities," says a Frankfurt banker. "They should observe the market constantly and intervene if necessary to iron out anomalies between the Bund and other curves" (particularly the swap curve, which tends to reflect liquidity at times when market conditions are difficult). "Just by saving one or two basis points on borrowing, they could afford to have a debt office staffed with 200 whiz kids and make Germany the best credit in Europe," he says, proposing other innovations such as floaters, index-linked paper, and matching coupon dates and coupons to facilitate stripping.

But the Bundesbank retorts that it has heard little cogent argument in favour of these latest proposals. At the end of 1996 the Bundesbank finally responded to one of the banks' grievances by exempting repo business from the 2% minimum reserve requirement that applies to all deposits held by German-based banks.

Bundesbank sources now say that this reform might have been made much sooner had market participants marshalled their arguments in a clearer and more persuasive form. But it took several years of griping before repo dealers had convinced the central bank that lifting the minimum reserve on repos would not have a destabilizing effect on German money supply.

Likewise, in the vexed question of the federal bond syndicate (Bundesanleihe-konsortium), the central bank says it is not yet convinced by banks that criticize the way in which Bunds are sold in the primary market.

Bundesbank sources give the impression that they are completely enlightened and try hard to enlighten the finance ministry about the need to listen to the markets. But some Bund traders complain that the Bundesbank itself is old-fashioned in the way it organizes the syndicate.

The sale of Bunds in the primary market is done by a combination of syndicate quotas and auction by tender. On the first day of any issue, the inner circle of about 20 banks meets at the Bundesbank in Frankfurt to agree the terms of the deal. Then all 87 members of the syndicate are offered the bond at the predetermined rates. In practice, however, they have to buy according to their (secret) quotas or else risk losing those shares and possibly even their place in the syndicate following the next adjustment.

Bankers in Frankfurt claim that if the Bundesbank suspects banks are unhappy about buying their full quota it announces that another adjustment of the quotas is imminent, thereby putting pressure on banks to buy anyway, even if they have to sell on immediately in the secondary market and take a loss. "There is a certain pressure to bid aggressively," says Peter Coym, managing director at Lehman Brothers in Frankfurt.

The Bundesbank actively encourages this culture of fear in order to ensure every bond can be placed, even if the pricing is tight. So while "the general impression is one of complaints", as a senior Bundesbank source puts it, Bunds invariably sell in the primary market. The Bundesbank acknowledges that some banks may be tempted to assume a larger quota than they can place profitably in order to build up or maintain their quota, but assumes they can afford to do so only temporarily. So the Bundesbank believes the quotas, which it alone knows, are a true reflection of each bank's market share in the primary market.

Two days later, the bulk of the issue is distributed by auction, and this second stage is becoming far more important in terms of volume than the distribution quota. Since only about 20% to 30% of any Bund issue is actually placed in the market via the banks through the quota system, the wheels and cogs that turn on the first day of any Bund issue seem to be more about the Bundesbank's relationship with the banks in the consortium than with driving the Bund market.

By the time the first non-German banks ­ Morgan Stanley, Caisse de Dépôts et Consignations, JP Morgan and Lehman Brothers ­ were finally admitted to the inner circle last April, the group was already losing its clout as a forum for discussing the terms of the latest issue. Attendance at the circle's meetings, now held just twice a year for the Bund issues in January and July, is now largely a matter of prestige.

Even the Bundesbank claims to be surprised that bankers take the trouble to travel to Frankfurt from all over Germany for a meeting that lasts less than 10 minutes and where members of the inner circle rarely offer any comment on the Bundesbank's pricing suggestion. Many of the Frankfurt-based members are keen to return to their trading rooms as soon as the terms have been agreed.

Indeed, the dialogue in the inner circle has become so sparse that the Bundesbank's credit and financial markets department has set up regular discussion groups with heads of fixed income and Bund traders in order to hear the market's views on Bund issuance. Typically traders ask to discuss the tender system at the Bund auctions, the range of Bund maturities and the marketing of non-Bund public paper to new groups of investors.

Some bankers still hope that the Bundesbank is operating this combined quota and auction system as a transition to a primary-dealer system, but the central bank insists they are mistaken. It is unwilling to burden itself with a system to police the primary dealers, checking each maintains the required bid-offer spreads at the required times and preventing dealers from engaging in arbitrage at the issuer's expense. Since the central bank still sells about one third of each public debt issue itself, in order to regulate the market, it doesn't require the same service from the banks. And according to the Bundesbank, none of the syndicate banks has yet volunteered to take on any greater responsibilities in return for being named primary dealer.

Bundesbank and market participants are at one, however, on an issue the central bank considers far more crucial. Despite pushing from the banks and gentle shoving from the Bundesbank, the finance ministry in Bonn has still not decided whether to convert its Bund debt from Deutschmarks into euros at the beginning of Emu in 1999. Although new German sovereign issues will be denominated in euros from that date, the indecision about conversion still leaves the huge existing debt in limbo. Despite the Bundesbank's substantial influence with the finance ministry ­ it gives the understaffed debt office in Bonn vital help with the organization and planning of Bund issuance ­ the ministry has not yet budged.

Bund traders are asking whether the old Deutschmark debt will still offer sufficient liquidity if it is not converted into euros. They believe that in two years' time liquidity will quickly move into the euro, particularly if other significant sovereign issuers switch fully into euros on that date. The markets may move against the Bund if it does not convert.

The Bundesbank argues that at least some of Germany's existing sovereign debt will have to be switched into euros in two years in order to provide sufficient market liquidity "avoiding a split in the market which would inevitably mean a loss of liquidity and loss of competitiveness", says the Bundesbank's Gaddum.

With the UK's future in Europe uncertain, France has become Germany's great rival in this particular race. The Trésor in Paris has already pledged to convert all OATs (French government bonds) into euros at the beginning of 1999.

Furthermore, France has a helpful tradition of issuing in Ecus. Austria, too, may be a contender. Its sovereign issues are trading at about the same level as Bunds, making them a good substitute. In January, the Republic of Austria launched a Ffr5 billion ($880 million) issue which gave the issuer the right to redenominate the bonds into euros.

Bund issues in Ecus or any other currency have never been seriously considered in Germany, where public opinion cherishes the Deutschmark and bitterly resents giving it up for an new unknown currency. Since the Bund is marketed heavily to retail investors, the finance ministry may procrastinate until the last possible moment ­ the abolition of the Deutschmark in 2002. And it will cost the finance ministry up to Dm400 million to redenominate all its debt. That is cash the government can ill afford to spend in a single year.

Nevertheless, some of the large liquid issues traded by international investors will probably be converted at once. Investors should not expect any rapid decisions however. The legislation needed to bring about this is not scheduled to face the German parliament before the summer of 1998.

Even more unhappily for Bonn, some economists suggest that Germany's future position as a sovereign debtor will not be determined by the Bund's liquidity in the market after 1999, but by pricing. That in turn will be determined by the success or otherwise of German economic policies. At present, these are in a parlous state.

Indeed, Bonn's inability to make a decision has come to symbolize the German government's apparent failure to come to terms with its structural problems. In January unemployment leapt from just over 4 million to nearly 4.7 million and is now racing towards five million. Before the statistics were published the government had failed to warn the markets just how large the rise would be ­ it appeared to come as a shock to the government too.

Both the state pensions scheme and the entire taxation system need urgent reform, but the coalition government in Bonn seems incapable of drafting the legislation and putting it through parliament within a few months. Every proposed detail is discussed by party leaders in innumerable horsetrading sessions. Public confidence in the government is waning, and the markets are following.

The rise in unemployment at the beginning of this year placed a huge new burden on the social insurance budget. On present showing, Germany seems to have no chance of reducing its budget deficit to 3% of GDP by the end of this year when EU countries' economic performance is measured to see which qualify for Emu.

Germany's economic problems may well push up interest rates again. Although this may attract investors, higher rates are likely to undermine the Bund's status as a benchmark.

But the final straw could be if Germany has to revise its borrowing targets once again. That would not only dent its Maastricht performance, but would probably do serious damage to the Bund's standing in the markets, where it remains the premier sovereign issue. Economists believe that Germany may well have to borrow even more. It is telling that net new debt in 1996 was revised from Dm59.6 billion to Dm78.3 billion in the space of a few months. This year's target is Dm53.3 billion.

Traders say if the Deutschmark future ever starts to hedge against the French OATs price rather than the Bund, the race will be lost. If the financial markets lose faith in the Bund, it could reverse all the progress the finance ministry and the Bundesbank have made, turning the Federal Republic of Germany into a less popular, less significant borrower which has to pay more than its neighbours to borrow money on the capital markets. It could take more than three people to put that right.