Introduction
A market for debt securities is developing rapidly in Kazakhstan. At the beginning of January 2002, the volume of corporate debt securities in Kazakhstan had grown from zero to more than USD400m. Twenty-seven bank and non-bank corporations -- large and small -- have issued bills, notes and bonds with maturities ranging from three months to seven years. In addition, the first mortgage-backed security in the former Soviet Union was issued in August 2001. Earlier issues have matured and been redeemed and, so far at least, there have been no defaults. In the next three months, some USD30m of new issues will come to market.
The appearance and dynamic growth of the debt securities market in Kazakhstan must be attributed, in large measure, to a USAID/Pragma-sponsored initiative emphasising the development of debt securities rather than equities, and to the National Bank of Kazakhstan (NBK) which lobbied and manoeuvered for the development of private pension funds. Without the private pension fund system there would have been neither domestic institutional money to invest in fixed income nor the professional money managers to invest it.
This article examines the special Kazakhstani circumstance which favours development of a debt securities market, and details the programme USAID has undertaken to promote and accelerate debt security issuance. In concluding, the authors suggest that, in remonetising economies and rebuilding institutional infrastructures in countries of the former Soviet Union, privatising debt -- i.e. developing debt securities markets -- is as critical as privatising equity. In some ways, in fact, it is more important.
Background
Kazakhstan is a vast, sparsely populated country. At 2.7 million square kilometers, Kazakhstan is four-fifths the size of India. By contrast, at 14.9 million souls, its population is only 2% of the subcontinent. And its workforce smaller yet: 6.9 million people are gainfully employed in Kazakhstan, and only 27% of those -- 1.9 million -- in industry.
In Soviet times, Kazakhstan was in many respects as much client state as it was republic. For consumer goods, intermediate industrial products and much of its processed food supply, Kazakhstan relied on the manufacturing capacities of Russia and other republics of the USSR. As a result, after the breakup of the Soviet Union, Kazakhstan found itself without a diversified industrial manufacturing base. Most of Kazakhstan's industrial capital stock is deployed in oil drilling and refining and the mining of ores and precious metals.
The structure of the economy Kazakhstan inherited from the USSR is important in two respects. First, the concentration of the country's capital stock in a few strategically important, capital-intensive industrial enterprises is not conducive to rapid privatisation. The working capital demands of these enterprises naturally limit potential buyers to cash-rich multinational corporations whose primary interests, it is feared, might not necessarily coincide with those of the people and government of Kazakhstan. Many Kazakhs view these enterprises as the national patrimony; to them, selling the enterprises off to multinational corporations means abandoning control of Kazakhstan's future wealth and destiny to faceless boards of directors in London or New York or Frankfurt. Given that the industries in which the enterprises operate are also strategically important -- oil and gas, precious metals, ores -- there is also the fear that selling the enterprises to foreign buyers might critically impair the country's ability to negotiate its future security. Reasonable or not, these and lesser arguments keep an ambitious 'blue chip' privatisation plan from getting off the ground. As a result, both foreign and domestic interest in the stocks traded on the Kazakh Stock Exchange (KASE) is lacklustre.
Second, due to the inherited economic structure, consumer product manufacture in Kazakhstan competes directly with long-established and largely better-financed light industries not only in Russia, but now in China as well. Consequently, neither foreign nor domestic investors have shown great enthusiasm for developing existing light industry or setting up green-fields ventures in the non-strategic sectors of the Kazakh economy. The close trading relationship with Russia further disadvantages Kazakh industry by putting severe constraints on the National Bank's conduct of monetary policy; the success of Kazakh light industry is, in critical measure, dependent on less-than-predictable Russian monetary policy. Light industry in Kazakhstan has been privatised, but perceived constraints to growth, profitability and sustainability dampens investor interest in its shares and puts limits on the trading on KASE.
In other respects, the Kazakh economy shares a number of characteristics with the economies of Russia and other states of the former Soviet Union. Eight years of devaluation and inflation have largely demonetised the economy; at the end of March 2000, money supply was only 14% of reported GDP. Persistent inflation, often driven only by devaluation, has forced the national bank to keep interest rates at levels unattractive to tenge-based manufacture; commercial bank intermediation in the economy is, therefore, insufficient to meet real demand. The relative shortage of money in the economy forces many industrial enterprises to engage in barter or other moneyless payment arrangements which by-pass the fractional reserve banking system, severely limiting the National Bank's ability to remonetise the economy.
The low rate of commercial bank lending (only 8% of GDP in 1999) was due not only to a shortage of money, but also to the perceived shortage of creditworthy industrial borrowers. Barter, of course, is not the most transparent form of transaction. A large percentage of barter transactions on an enterprise's income statement does not inspire commercial bank confidence in the creditworthiness of potential borrowers.
Likewise, continued devaluation and inflation do not inspire the population's confidence either in commercial banks or in the national currency. Understandably, personal savings tend not to go into commercial bank deposits or tenge-denominated annuity products, but rather into dollars hidden under mattresses or stuffed into old socks. As a rule, money under mattresses is meant for rainy days, not for investment. Mattress money exacerbates the liquidity problem in banks and industrial enterprises. Money that doesn't go into bank deposits can't be re-lent. As in Russia and other countries of the former Soviet Union, the Kazakh fractional reserve multiplier effect is, in real terms, close to zero. Money supply can't expand very fast if there are no deposits to multiply. And economies can't grow faster than their money supplies expand.
The investment picture in Kazakhstan was made worse by the August 1998 treasury default in Russia. At least, temporarily. In 1999, Kazakhstan was again forced to devalue to bring the tenge--ruble exchange rates back into equilibrium, and as a result of the devaluation, commercial bank deposits shrank, and along with them, the money supply. Shell-shocked by Russia's default, foreign investors fled Kazakh markets in droves. This, coupled with the Asian crisis, aptly illustrated the destabilising capability of underdeveloped debt markets. Asian domestic debt markets were slow to develop due to the predominance of banking systems, fiscal surpluses, and the lack of disintermediation. The disruption in capital flows eventually engulfed the region, having negative consequences for the economic, political, and social order in many countries. It also served as another reason for the flight of foreign capital investment from Kazakhstan. Through a quirk of geography, Kazakhstan was situated between two seismic financial meltdowns. Foreign investors did not differentiate.
With the value of bank deposits almost halved by devaluation and foreign funds fleeing in fear, the largest stock of capital in Kazakhstan became mattress money. And, of course, mattress money isn't for investment.
Pension funds, on the other hand, are.
The Central Asian Fixed Income Conference
In July 1997, long before oil prices, defaults and devaluations became issues, the Republic of Kazakhstan adopted the 'Law concerning Pension Provision from Accumulation Pension Funds'. This law called for the creation of private pension funds into which workers' mandatory pension withholdings could be paid as an alternative to the pay-as-you-go State Pension Fund. The law came into effect on January 1, 1998, and by April of the same year, private Kazakh pension funds began receiving workers' contributions. Today private pension funds account for more than 67% of total pension fund accumulations.
The leading proponent of pension fund reform in Kazakhstan was the National Bank. Concerned, as national banks should be, with increasing the national savings rate, the Bank's officers pushed for the creation of accumulation pension funds, where workers' contributions could be invested in the local economy at competitive rates by professional asset managers. The law requires that pension funds invest half of their receipts in Government of Kazakhstan securities, but the other half may be placed in domestic corporate stock and bond issues. In Kazakhstan, pension fund investments are closely regulated and monitored by the National Securities Commission.
USAID was not the first to realise that pension fund accumulations represented a new source of private investment funds or that, at projected rates of growth, they would soon rival mattress money as the largest stock of capital in Kazakhstan. However, it was perhaps the first to understand that pension funds are primarily fixed income investors. The first priority of accumulation pension funds is capital preservation; therefore, pension funds must largely forego speculative capital gains in favour of predictable future income streams. Fixed income instruments were the only investments Kazakh asset managers should consider.
But there was a problem. The only fixed income securities available for investment in Kazakhstan were short-term Government of Kazakhstan treasuries and Eurobonds. At the beginning of 1999, pension fund asset managers had more than 95% of their investments in state securities. Such concentration of investment in one asset class would spell doom for pension funds should anything similar to what occurred in Russia be repeated in Kazakhstan. Kazakh asset managers obviously needed to diversify into other fixed income instruments to mitigate their risk exposure.
Early in 1999, USAID recognised that, in the absence of blue chip privatisation and predictable economic conditions, it should reorder its priorities, changing its focus from equities to concentrate on development of a fixed income market in Kazakhstan. With this objective, in April 1999 USAID, with the support of Pragma Corporation -- the USAID contractor tasked with the Securities Market Development (SMD) project -- organised the first Central Asian Fixed Income Conference. Its goal was to direct the attention of professional participants in the Kazakh marketplace to the importance of bonds as instruments for both investment and borrowing. The conference highlighted both corporate and municipal debt issuance.
Of course, the conference helped USAID focus its attention on the organisational structure needed to promote the development of a debt securities market in Kazakhstan. The organisational structure was similar to that of an investment bank. The primary functions were: corporate finance, new product development and advocacy of legal structural reform.
Corporate finance
Since 1998, the SMD project had been educating Kazakh companies on the benefits of listing their stocks on the KASE. With the focus now on developing a fixed income market, the project redirected its efforts to identify, companies with financial needs traditionally met by debt issuance -- new equipment purchases, project development, debt consolidation. The most common need the project encountered, however, was working capital finance. In the absence of commercial bank intermediation, Kazakh companies were in dire need of working capital.
Having identified companies and their specific needs, Pragma assisted company management in the procedural aspects of bond issuance: securing the services of an auditor and preparing for audit; preparing the offering memorandum; registering the issue with the National Securities Commission and the Depository (Registrar); and making application for listing the security on the Kazakhstan Stock Exchange.
KASE's four listing categories -- A, B, OTC I, OTC II -- differentiate disclosure and financial standards. 'A' listed issues have the most stringent requirements and are automatically qualified for pension fund investment.
Upon listing on KASE, the project then assisted the companies in negotiations with broker--dealers who subsequently placed the issues with institutional buyers. The entire issuance process, from initial financial analysis to final placement, was inevitably long, if not always complicated. Pragma worked with AO Almaty Kus, a poultry processor, for nine months on a one-year USD3.5m issue. The average length of time between inception and issue is about seven months.
Not surprisingly, initial 'bond' issues in Kazakhstan bore a striking resemblance to commercial bank loans: they were for relatively small face amounts (as little as USD75,000) and for very short terms (three to six months). And all were unsecured, backed solely by the faith and trust of the issuer. These three characteristics—small amounts, short-term, unsecured -- reveal a great deal more about the nature of debt in Kazakhstan than simply the lack of commercial bank intermediation. Among other things, they reveal the need for new financial products, credit enhancements and infrastructure (legal and institutional) reform.
New product development
Mortgage-backed securities
There is no need to re-invent the wheel. Most of the financial products needed in Kazakhstan can be imported, though imports might have to be modified to some degree to meet local requirements. Mortgage-backed securities are a case in point. The first question, of course, is: are mortgage-backed securities really needed in Kazakhstan? There are three answers to this.
First, the demand for mortgage-backed securities is currently very limited. In fact, in 2001 there were enough seasoned mortgages in Kazakhstan to secure only one USD1m issue.
Second, demand and need are not the same thing. Few would argue, for example, that after eight years of severe depression the Kazakh economy doesn't need a strong housing construction industry. Housing construction requires finance, and home-buyers need mortgages -- the longer the term, the lower the monthly payments. The point is: Kazakhstani banks need a means of funding loans, the longer terms of which more closely match the useful lives of the assets they finance. Whether the underlying instruments are mortgages, equipment leases or car loans, the mechanism for pledging bundled financial instruments to secure bond issues is the same. As a result of the mortgage-backed issue (Lariba Bank), a mechanism, including the supporting legal infrastructure, is in place for banks to use.
Last, diversification of pension fund assets demands a full array of derivative financial instruments, of which mortgage-backed securities are just one. The need for pension fund diversification also drives SMD's efforts to add credit enhancements to otherwise standard issues and to improve the quality and clarity of bond indentures. The Lariba Bank mortgage-backed issue carries a guarantee by USAID's Developmental Credit Authority (DCA) for 50% of principal. The Lariba bond indenture includes clauses and language adapted from US boilerplate bond documentation; the indenture is about twenty pages in length, compared to the six pages common to most standard issues.
Social Obligations Bonds
USAID realises that, while most financial products can be imported, some will have to be homegrown. The Social Obligations Bond (SOB) will be a home-grown product.
Under the terms of profit sharing agreements (PSA), foreign oil companies operating in Kazakhstan are obligated to make annual payments to develop the local social infrastructure of the oblasts in which they work. While substantial, the annual payments are nonetheless often insufficient to fund the large-scale infrastructure projects most sorely needed in some areas: water purification systems, highways and roads, housing, etc. And, of course, municipalities and oblasts cannot budget for those kinds of projects on the basis of income streams that have to be renegotiated every year.
However, since the annual payments are actually contractual, they can be securitised; i.e. three or five or seven years of contractual payments can be bundled and pledged as collateral to secure a bond issued by the foreign oil company. The bond will be targeted for sale to Kazakh pension funds.
The structure of the bond itself is fairly straightforward; securitisation is not new financial technology. Still, several features have been incorporated which enhance the transparency of the use of proceeds. Projects will be determined by a Selection Committee made up of representatives from the oblast, the oil company, the Agency for State Investments (signatory to the PSA), the National Bank, the National Securities Commission and an international organisation (World Bank, IMF, EBRD) as observer. A fiduciary trustee will administer all disbursements out of the proceeds of the bond. The oblast's portion of the interest payments will be escrowed out of the proceeds and the escrow account administered by the trustee.
The Social Obligations Bond project is now being developed by a working group chaired jointly by the Agency for State Investments and Pragma. The project has been vetted by all interested ministries (Energy, Finance, Economics) and has garnered the support of deputy prime ministers and senators. The akims (governors) of both Mangistau and Atyrau oblasts have taken a keen interest in the proposed issue, as have most major oil companies.
Hidden agendas
Like all the financial products the SMD project is developing, the Lariba mortgage-backed note and the Social Obligations Bond have two secondary objectives: extending the yield curve and increasing transparency.
Previously, the yield curve in Kazakhstan was little more than a yield dot. Eighteen months ago there was only one security issue with a term longer than two years, and most issues had terms of a year or less. While shorter terms are consistent with working capital finance, they clearly impair a corporate treasury's ability to amortise the cost of finance over the useful life of an underlying asset. Likewise, shorter terms prevent commercial banks from matching liabilities with longer-term assets; mismatched maturities lower liquidity coefficients and can give rise to additional interest rate risk. In the end, of course, consumers foot the bill for these financial inefficiencies. This is particularly clear in the case of mortgages, where the monthly cost of homeownership rises dramatically in inverse proportion to the term of the mortgage.
Shorter maturities are not uncommon in high inflation economies or in societies where the future is viewed more with suspicion or dread than with hope. Hope is an asset bonds can't really finance, though their terms and rate structures clearly impart shape and substance to future values. USAID's concern with extending the yield curve, however, is less metaphysical in nature: under the current circumstance in Kazakhstan, securities with shorter maturities actually risk disintermediating commercial banks, especially in cases of working capital finance.
Unlike commercial banks, pension funds do not have reserve requirements tied to explicit refinance rates, and they don't have to pay for deposits. Largely for this reason, over the past twenty months interest expense to corporate bond issuers was on average eight full points below bank rates of comparable maturity. Recently, however, the spread has begun to narrow. Falling inflation rates and the currency stability higher oil prices have brought have allowed the National Bank to lower the refinance rate. And recognising the competition pension funds represent, commercial banks have begun entering the short-term corporate finance market, where they rightfully belong. Banks bought 80% of the recent Kazakhoil issue. More important, smaller corporate bond issuers, upon preparing second issues, have been lured away by banks. Having already issued and retired notes, former corporate issuers make ideal bank clients; they come with full documentation, audits and a credit history that inspires confidence.
Credit ratings may not make for inspirational reading, but they too build confidence. Before undertaking the Lariba Bank mortgage-backed project, USAID assisted the bank in getting rated by Standard & Poor's. In spite of being one of the smallest banks S&P has ever rated, Lariba Bank received a B-rating, equal to that of the largest banks in Kazakhstan. And USAID has been working with EA Ratings in Moscow, an S&P-associated ratings group, to develop a local ratings agency in Kazakhstan. Also developed is a Kazakhstan bond index. While not credit enhancements per se, ratings and indices help institutionalise the bond market process and build confidence among its participants and observers.
In the absence of hope, confidence might do. Confidence in the courts and the legal basis also helps.
Reforming the legal basis
New financial instruments can hit legal snags. During development, both the Lariba mortgage-backed note and the Social Obligations Bond ran into legal obstacles. With the Lariba note, USAID was able to get around the legal problem by substituting existing local practice for a proposed imported construct that local law does not support. More complex tax and legal issues with the Social Obligations Bond are still seeking solutions.
In the Lariba case, local law requires that liens and collateral pledges securing loans go directly from borrower to lender. Between a borrower and a single lender -- say, a bank -- the law is adequate and perfectly clear. In the case of debt issues, however, where there is a borrower and multiple lenders (potentially, thousands of individual bondholders), the law becomes impracticable and even counterproductive. It actually makes securing a bond practically impossible: every time the bond changes hands, the security pledge would have to be re-registered. By implication, the same law also prevents use of a fiduciary trustee who would hold the collateral pledge in trust for all bondholders, whom the trustee would represent in negotiations with the issuer or in the courts in case of default.
Worse yet, even if it were possible to secure an issue using a trustee, under current law bondholders lose their right to the collateral pledge if the bond issuer goes bankrupt. In the case of bankruptcy, all of the bankrupt issuer's assets, pledged or not, revert to general obligations available for liquidation to pay creditors' claims.
To circumvent the legal deficiencies and improve the bondholders' position in case of default or bankruptcy, USAID enhanced Lariba's issue with a guarantor (DCA) who essentially indemnifies the bondholders against loss of principal. The Lariba mortgage pool, which secures the issue, is pledged to the guarantor, who not only enjoys higher priority of payment in case of bankruptcy, but is also capable of managing the mortgage pool in case of default. Of course, having USAID/DCA as a guarantor, the Lariba issue received an 'A' listing on KASE and pricing reflected lower risk. Deutsche Bank Securities acted as financial advisor for the issue.
While the guarantor mechanism is satisfactory under the circumstances of the Lariba issue, it is only a stop-gap measure. USAID is working with lawmakers in Astana to remedy the deficiencies in the pledge law which preclude the use of bond trustees. Law, of course, is slow to change without a significant constituency behind the changes. Unfortunately, the best catalyst for change is default. Default on a bond issue would bring to light all the shortcomings of the current law and create an instant constituency of the bondholders who suffer losses. A default will occur eventually: it's almost certain. In the interim, lawyers are drafting new trust and pledge language, and lobbying in Astana for an improved legal basis for debt issuance.
Many areas of Kazakh law, including the tax code, will require revision in order to genuinely improve the legal basis for debt issuance. However, it is only in developing and issuing new products that specific deficiencies or contradictions in the law get discovered. It's a long process, but it has begun.
Conclusions
It is almost axiomatic that the defining difference between the economies of Soviet communism and the Western free world was private property and the right of ownership. Bt that is only partially true. There was private property in the Soviet economy -- dachas and garden plots and cars; what was denied was the right to use private property to earn a profit. The 'means of production' was a monopoly of the state.
Among the means of production, of course, is money. The monetary component of working capital is as much an asset as a brick or mortar. In fact, without working capital, bricks and mortar are virtually worthless. It takes money to make money, as they say. And as Joseph Schumpeter once wrote: "Money is credit . . .".
The massive privatisation programmes that followed the collapse of the Soviet Union were more successful at privatising bricks and mortar than at transferring wealth. In Russia, whose privatisation programme was perhaps the most aggressive, more than half the country's industrial capacity was lost to insolvency and bankruptcy. By some estimates, Russia's industrial capacity is only 40% of what it was ten years ago. Losses in other countries of the former USSR might have been less dramatic, but nowhere in the region has industry flourished as a result of privatisation. Some economists doubt even that industrial gains since the massive devaluations of 1998--99 can be sustained.
One of the reasons for industry's poor performance since privatisation is the lack of working capital. Specifically, banking systems were either unwilling or unable to make industrial loans; banks didn't intermediate. In the banks' defense, in most cases there wasn't much money to lend. The economies in which they operated were -- and in some cases, are still today -- demonetised. Money supplies in the range of 13-18% of GDP simply can't fund all transactions in the respective economies. As a rule, barter and mattress money don't foster strong economic growth; they certainly don't grow the money supply.
In this context, Kazakhstan is somewhat unique. Kazakhstan didn't rush to privatise the real jewels of its admittedly small industrial base but, with the creation of a private accumulation pension fund system, it did engineer an alternative source of investment capital to the commercial banking system. As important, pension funds by their very nature have a different focus and longer investment horizons than commercial banks. More important still, unless commercial bank deposits grow substantially over the next few years, by 2005 pension funds could become the largest source of investment capital in the country, with total accumulations of more than USD3.95bn.#
Thanks to the pension fund system, Kazakh industry, if properly educated in the issuance of corporate debt instruments, will have ample money to finance its needs. Perhaps even enough to finance the privatisation of Kazakhstan's blue chip companies. And future Kazakh pensioners will be able to look forward to markedly better retirements than pensioners now can expect: a ray of hope, so to speak.
There is, however, another aspect of the Kazakh case which tends to escape notice. That is the notion of the privatisation of debt. Ten years ago, in the last days of the Soviet Union, there was no debt but government debt. Private citizens didn't have mortgages or car loans, and there was no such thing as a Soviet Express card. State enterprises might have carried loans from state banks, but since the state owned both the enterprise and the bank, the credit and debit eventually cancelled out. In short, the government had a monopoly on debt. Or, in Schumpeter's view, a monopoly on money itself. Credit, after all, is money.
As the Russian experience demonstrates, privatising equity faster than you privatise debt can yield unwelcome results. But, while the transfer of ownership in bricks and mortar is fairly straightforward, transferring the right to borrow money is rather more complex. The psychology of ownership and debt are actually quite different. They require different legal bases and financial institutions, and they create quite different constituencies.
Ownership imparts the right to sell or trade, and understandably it doesn't always take the long view. Debt, on the other hand, especially debt secured by an underlying asset -- a car, an apartment, a new manufacturing line -- encourages maintenance and proper operation, and teaches respect for residual value. Debt necessarily takes the longer view. And it obviously requires some degree of confidence in the future. In the end, of course, it's not bricks or mortar or even money that makes economies grow. It's confidence in the future. For those who take care of their future, the present tends to take care of itself.
