Funding the budget deficit using gov't bonds: A conundrum
Mphoeng Mphoeng | Friday May 28, 2021 16:45
One of the biggest, most critical issues from the budget, was a never-before-seen budget deficit of P6 billion (about three percent of GDP). Combined with a revised deficit of P21 billion for year 2020/21, this meant that government was short of money to be able to run its programmes and commitments this year. Minister Matsheka also announced his plans on how he would cover that shortfall using the following avenues: borrowing from local investors by issuing bonds, borrowing money from external lenders, tapping into foreign reserves and increasing taxes and improving collection of levies etc.
Consistent with the strategy, since January 2021 Government has attempted to raise P4.5 billion by asking local investors to buy government bonds at auctions held on a monthly basis. Government has only successfully raised P1.549 billion (30%) of what it has intended. In the May 14, 2021 edition of Mmegi, the Governor of the Bank of Botswana (BoB), Moses Pelaelo decried the low uptake or interest in government bonds (essentially lending money to Government). The Governor expressed that they will undertake an exercise to find out why investors seem not to be interested in the bonds though they have asked for them in the past. This article therefore will try to explain this phenomenon and what Government might need to do in future to make its effort to raise funds for the deficit more successful.
Firstly, let us examine how Government attempts to borrow money from investors. Government via the MoF gives an instruction to BoB on how much it would like to borrow from investors in a particular quarter. BoB then checks sentiment with local investors via discussions with commercial banks. BoB then announces how much it would like to borrow, for how long and at what interest rate. This is what is termed issuing bonds. Investors then bid at an auction at the price they see fit to purchase those bonds. The person offering BoB the best prices will be awarded those bonds which are then listed on the Botswana Stock Exchange (BSE) and can be traded until the time on their contracts elapses.
So it is very possible that investors will express interest in bonds but bid at prices that BoB sees as unpalatable and therefore will choose not to honour and take up the bids. This is what has been happening at least for the past year. Why is this the case? The answer lies in how bond market investors make their money.
The biggest issue a bond investor has to worry about is how they believe market interest rates will behave over the life of the bond. Say BoB issues a six-year bond like they did on May 2021. Bond investors have to forecast what they think will happen to interest rates between now and 2027. Botswana is now currently at the lowest interest rates it has had in its cycle, so it is easy to forecast that interest rates will go up in the next few years. Unfortunately due to how bonds work (the explanation is too complex for this article), it means when interest rates go up, bonds will reduce in value and an investor would lose money. To avoid this problem, an investor has to price their bid at an auction lower in order to compensate for the losses they forecast to experience in the future. This isn’t necessarily an issue in other countries that have a more developed bond market that have mechanisms to ensure investors can make money when interest rates go up or when they go down. In Botswana, you can only make money in one direction, which is down (another complex issue beyond the scope of this article).
This issue is further exacerbated by the fact that Botswana recently got downgraded by Moody’s (see previous article in Mmegi or on my website about credit ratings) which means investors now view Botswana as having increased risk of not being able to pay back its commitments to investors. The increased risk would have made investors want to be compensated for the additional risk they are taking so this would have lowered the price they bid even more.
The implication of this is that investors would be happy to invest in Government bonds but only at prices that they are comfortable that they wouldn’t lose money in the long run as interest rates rise. Unfortunately for government this would mean if they were trying to raise XXXX, they may only get paid YYYY at those prices but be expected in the long run to pay the full XXXX back. So essentially this is the conundrum we are facing as a country and in the bond markets. Due to the undeveloped nature of our market, we are now faced by two competing forces: Government wants to borrow money from local investors but is in somewhat denial of what investors want because this would mean they take on more expensive debt. On the other hand, investors want to invest in government bonds but at these level of interest rates, they’re afraid that the only way for interest rates to go is up, which would make them lose money; so they choose to bid as low as possible to compensate them for “guaranteed” future losses. This leads to a stand-off.
Unfortunately for the average Motswana, this standoff means either the Government won’t be able to get funded by local investors and therefore the government could struggle to pay for commitments meaning Batswana would suffer. On the other hand, if investors pay at the price level that the Government wants, this means that years from now the investors would lose value and money which would affect the average Motswana because this would affect the values of their pensions and pay-outs.
This conundrum wouldn’t exist if the country had a fully functioning developed capital market and whilst the easy blame would be to look at the Government or the BSE, the reality is that the under development is created by a lack of interest in its development by the commercial banks and the investment industry.
The reality is that the market participants have been able to be profitable without being innovative (as has been the criticism levelled at commercial banks for many years). They’ve never had an incentive to want to put in the work to develop our markets.
Until the market participants are forced to stand up and play their true role, we will continue to be saddled by the current conundrum. In the meantime, Government will have to continue scratching their heads on how to access the investment funds sitting in our capital markets.
*Mphoeng is a Director at Spectrum Analytics, a local citizen owned data analytics company that offers services in Digital Transformation Consultancy, application development and process automation and improvement. Previously he worked for University of Botswana as a Lecturer in Accounting and Finance, Botswana Investment Fund Management (BIFM), Standard Chartered Bank and Bank of Botswana