Financing a crisis: Europe’s sovereigns fund pandemic response
The world is facing an unprecedented crisis, the economic effects of which we are only beginning to understand. Sovereign funding will be at the heart of the effort to mitigate those effects. GlobalCapital hosted a virtual roundtable in May to discuss the effects that the pandemic is having on sovereigns’ borrowing requirements and market access, and how they are handling the situation.
Global lockdowns mean devastating losses for businesses. However, thanks to the lessons of previous financial crises, sovereigns are stepping up and shouldering a great deal of the economic burden.
Guaranteeing incomes, extending credit support and funding health services is expensive, particularly when tax revenues have fallen sharply. But sovereigns have put their economies in the best position to profit from recovery once the pandemic is overcome.
That means raising a huge amount of extra funding. Sovereigns have hit the markets early and often, and for larger sizes than ever. Over the last three months, issuance by public sector borrowers is 70% higher than the same period last year. For sovereigns, the figure is 315%.
They have been forced to adapt swiftly, all while working remotely. That has meant an increased reliance on technology, but panellists agreed that a push towards automation and digitalisation would have to wait. They prefer to rely on tried and tested methods, which have held up well to the challenges of remote working and the increased requirements.
Increased funding needs might have made conditions tougher, but fortunately investors are more eager than ever for sovereign assets.
Part of this stems from a need to deploy cash where it can be held safely. However, there is an increasing focus on ethical investments, and with sovereigns doing the heavy lifting for the coronavirus response, buying their bonds offers a way to help finance the fight against the virus and support the recovery.
While the panellists welcomed the rise of socially-minded investors, all felt that issuing bonds with segregated proceeds to address the effect of the Covid-19 pandemic was the wrong move for government debt offices. They prefer to leave that instrument to others in the SSA sector and to preserve the integrity and liquidity of the sovereign curve.
Sovereigns have also been helped by the European Central Bank’s expansion of quantitative easing. The Pandemic Emergency Purchase Programme has helped European government bond spreads to Bunds to slip back to within touching distance of where they were before the virus reared its head.
The European Commission is also acting to support its member countries, unveiling new schemes to provide financial support.
But even with these measures in place, the drastic increases to borrowing needs inevitably lead to questions of debt sustainability, particularly as growth is damaged by the virus. The spectre of the eurozone sovereign debt crisis still looms large in investors’ minds.
However, the panellists offer convincing reasons for optimism, demonstrating that their strategies are still sustainable and they remain the strongest credits available.
Participants in the panel were:
Ioannis Rallis, executive director, head of SSA DCM,
Pablo de Ramón-Laca, director general of the treasury and financial policy general secretariat of the treasury and international finance (Spanish Treasury), Ministry of Economic Affairs and Digital Transformation, Spain
Cristina Casalinho, chief executive officer, Portuguese Treasury and Debt Management Agency – IGCP
Maric Post, director, treasury and capital markets, Belgian Debt Management Office
Moderator: Lewis McLellan, SSAs and MTNs editor, GlobalCapital
GlobalCapital: Tell us about your borrowing programme for the year and how it has been affected by Covid-19?
Maric Post, Belgium: We had announced a plan for €30bn of gross funding for the Belgian debt agency before the crisis. We actually took a two-step approach to the changes that we announced.
We first made an announcement at the end of March to highlight the fact that there would be additional funding needs, which was already obvious of course to the whole market at that stage.
We announced that we would fund these additional needs partially by an additional syndicated transaction and partially by using a greater number of auctions than our initial plans called for. We also announced that we would stop buying back bonds that mature in more than one year, and finally that we would probably increase our T-bill programme for the rest of the year. That was the initial announcement at the end of March.
During the month of April, we had some more robust work done by an expert group that that was helping the Belgian government on the economic forecast. They produced a forecast for the Belgium economy for 2020. We then could translate that into figures for our own funding plan.
The base case scenario that we’re working on is a contraction of the economy by 8% in Belgium, which would translate into a government deficit of 7.5% for this year. Translating that into federal government funding needs, we’re looking at almost €22bn of extra funding.
How are we going to fund that? We already took the first step before we actually had the details on the figures. That initial step was a very big syndicated transaction — a seven year new line of €8bn. That allowed us then to fill in the remainder of the amount by adding new auctions, and increasing our short term funding programme to €8bn.
So it’s a mixture of these measures. And of course, we are still monitoring everything on a daily basis, because, of course, the 8% contraction of the economy is a base case but rests upon a number of hypotheses on the further path of this crisis. As the situation develops, we will have to adjust our programme accordingly.
Cristina Casalinho, Portugal: As opposed to other European member states, the Portuguese government has not released our supplementary budget. Currently we are working on assumptions and forecasts from others. If we take the IMF and European Commission spring forecasts as a good proxy for what we may expect to have as a state deficit for this year, we’re looking at around 6%-7% of GDP.
I think it’s worth highlighting the fact that last year, Portugal produced a primary surplus to 3.2% of GDP and in the end an overall surplus of 0.2%. So we started from a very, very comfortable fiscal position. For this year, before the Covid-19 outbreak, the government projected an overall fiscal surplus.
In our worst case scenario, the increase in funding needs will be below €10bn — around €6bn-€7bn. That is what we consider to be a likely estimate of the impact.
As a result of this, we are accelerating the execution of our funding plan. In early March, when we reviewed our quarterly funding plan, we communicated to the market that we will increase the size of the Portuguese government bond auctions and we will also increase the size of the programme.
At the short end, there is also a substantial impact. We have brought our T-bill programme down by more than €4bn in the past three years. This year, we expect to move it back up to €15bn.
As well as increasing the size of the funding programme, we will be changing our schedule. Traditionally, every other month we use the first week to bring Portuguese government bonds to the market and for the second week, we conduct a bond switch.
Because of our increased needs, we’ll stop using the second window to do exchanges and instead, we may supply outright liquidity to the most recent benchmarks in case of need. We’ve been realizing that we need to provide more liquidity to at least two off-the-run benchmarks and we believe that we can use the second window to execute smaller auctions to provide liquidity to those securities and use that to make our market function a little better.
What I think is also interesting to point out is the fact that even if we take into consideration the very worst case scenario, it will still not take the gross borrowing needs of Portugal back to the levels that we executed in 2016 and 2017, when we were raising €27bn. For 2020, we don’t expect to go back to those sorts of high levels of borrowing.
It’s also worth remembering that our overall deficit will not be as high as it was in 2017. We were also repaying IMF loans then. Our funding levels now are far below what Portugal had when we were paying those official loans.
I’d like to mention two ways through which we have been able to handle the crisis and the increased funding requirement that comes with it. The first way is simply by having a wide range of products directed at different investor bases.
That allows us to identify different sorts of demand or different sorts of risk appetite and try to navigate those depending on the circumstances.
The second method is having a comfortable liquidity buffer. For instance, given the fact that we have very little visibility on the actual funding needs that we’ll have for the rest of the year, having a quite comfortable cash buffer allowed us to take some time and to have a better assessment of how the funding needs will increase. We learned this from the 2008 financial crisis.
Pablo De Ramón-Laca, Spain: Well, first of all, the Covid-19 crisis has changed the macroeconomic scenario in Spain just like everywhere else. We’ve recently presented our stability programme update, which shows a 9.2% fall in GDP.
Spain is particularly affected because of tourism, and because our population is concentrated in large cities, the pandemic has affected us particularly. And so the measures to flatten the contagion curve are particularly stringent. This is a health crisis above anything else, and so health considerations are paramount.
The fall in GDP will be very, very substantial. We estimate a deficit of above 10%. But then again, it is so uncertain that we really don’t know how much it’s going to be. Accordingly, we haven’t yet updated our funding programme.
It will be substantially bigger. That means bigger auctions. That means more lines. That means firing on all cylinders, short term and long term as well. But so far, we’ve seen that the market can take it and that it’s just a matter of co-ordination. It’s a tribute to the capital markets.
It’s not just the discretionary spending on healthcare and stimulating the economy. It’s the automatic stabilizers.
We don’t fully know how long our temporary furloughing scheme is going to last, and it’s all paid by the state. We don’t know what the impact is on tax revenues. We can estimate but we don’t know, and that affects the Treasury’s cash position. The best we can do is frontload and advance the programme.
We announced at the beginning of the year a net programme of €32.5bn, and this was just below €200bn in gross terms, including T-bills and medium and long term redemptions. We are obviously very well advanced in that, having issued €136.9bn in gross terms (€41.7bn of T-bills and €95.2bn in medium and long term products) but it’s going to increase. However, even with the new numbers, we already have a decent level of progress.
[Since this interview, the Spanish Treasury has updated its 2020 funding programme, from the original €32.5bn net issuance announced in January, to €130bn.]
Our ability to finance the rest of the programme depends on whether the capital markets continue to work. Fortunately, everything we see — monetary policy, investor demand, rating agencies’ constructive attitude — is favourable to that so we’re confident. We will remain flexible and adapt.
GlobalCapital: Ioannis, you’ve been on the front line for some of the biggest deals over the past few months. Have you seen any signs of strain?
Ioannis Rallis, JP Morgan: I think the market has really worked surprisingly well in this situation. We must not forget that there have been operational challenges for all of us. Trading and sales teams are now working from dispersed locations or from home. A lot of investors are working from home too.
We all had to make sure that we had the technical equipment to actually conduct our operations from home offices like the one you see behind me. Luckily, we have had a very good technology rollout at JP Morgan. We haven’t had any major lapses.
But you see a bit of a difference when executing deals. To give an example, given that people are not in their usual places, the response times for decisions can sometimes take longer. So we have to cope with those delays. That means we have to make sure that if you are going into a mammoth transaction, like the one that Pablo did, you have all the right people lined up and ready to engage. But it’s worked actually very well. So I’m positive.
De Ramón-Laca, Spain: The fact that that transaction was done with most people at home is a tribute to attitudes during the confinement and to the state of technology. Fifteen years ago, this would have been a disaster. The amount of GDP that is being generated with everyone at home would have been absolutely impossible 15 years ago. And it’s not just DMOs. Banks and investors are using retail technology — their home’s wifi — for a wholesale job of liquidity provision and hedging and risk management.
It is astounding that we could amass €97bn of orders and issue €15bn in a one-day transaction as smoothly as we have done so I think congratulations to the entire capital markets for making it possible.
Casalinho, Portugal: Yes, we should congratulate all market participants for being so quick to adapt to this new environment. Executions have been running very smoothly and we should be proud of what we have made of these very, very challenging times. Investors, issuers and bankers have all been rowing in the same direction, and avoiding adding any additional complications to the running of the state in this difficult period.
GlobalCapital: Certainly. It would have been unthinkable 15 years ago. Are the operational challenges having a knock-on effect on liquidity? Are you advising issuers to use different strategies?
Rallis, JP Morgan: When we look at market levels, we see different things. In general, European government bond spreads are still a little elevated relative to Germany, compared to where we started the year but we’re definitely off the peaks seen in March.
Liquidity both in cash and futures is lower than it usually is at this time of the year. For example, when we look at the market depth in Eurex futures for Germany, Italy and France, these levels are as low as they were in spring 2018 when we had the Italian elections.
But the primary market is showing a completely different picture, as we just discussed. Investors are very happy to engage at these levels. There’s confidence in European economies and European institutions, and obviously we have the ECB programmes in the back, which are very important.
Once PEPP was announced, that made a big difference to how investors viewed the spread widening and the sorts of trades they wanted to put on. Initially, we told issuers to focus on the short and medium maturities because we had a feeling, and evidence from secondary flows, that asset managers saw a lot of outflows, and they were typically the ones supporting the longer maturities.
But that has turned now. We have a lot more duration demand now in the market than we had in March. So we are much more confident now telling sovereigns to tap maturities of 10 years and longer. And we’ve seen with a couple of transactions that even 30 years attracts a lot of demand.
GlobalCapital: Maric, have you had to adjust your strategy, as well as the volumes you’re raising?
Post, Belgium: We haven’t had to make major changes in our strategy, but the market has changed somewhat. We saw a significant period in March where there was understandable hesitation from the investor community. However, fortunately the European Central Bank launched the PEPP. Clearly, that was a major factor in turning the market around.
In terms of execution, we chose seven years for our big benchmark transaction. We brought it forward, frontloading it to ensure we had enough cash on hand for requirements. There was still a little bit of hesitation in the market at that point, but it is one of the maturities where you will find the deepest mix of investors available, so for big transactions that makes a lot of sense.
In terms of strategy, going forward we plan to stick to the bigger outline of our debt strategy. We have a certain minimum average maturity of our debt portfolio that we still wish to stick to. Of course, I echo all of the remarks about the uncertainty that we will have going forward, but with the figures that we are working on now, we will be able to stick to the average maturity goal.
Casalinho, Portugal: We also didn’t change our strategy substantially, apart from frontloading as much as possible.
We decided to execute the seven year syndication in April because we thought that was the right time. Seven years was the deepest point in terms of demand.
Another little change that we decided to make was to introduce a large retail product programme. We keep it in the back of our minds as something we can revisit in case of need. Sometimes we wind it down and sometimes we scale it up. So we keep this as an option. That’s the only thing that we may be changing as we may move on with scaling up our borrowing.
De Ramón-Laca, Spain: After the PEPP announcement, we had an auction the following day. That auction went very smoothly, without a single purchase by PEPP. Only the announcement had happened.
The following week, we launched the seven year, surprising the market. I like to think we pioneered that tenor. It had been touched before by Italy, but a few years earlier. Our transaction went well. There was a wider new issue premium but that’s just the market adapting to the new reality. Investors are there and they’re willing to engage. It’s just a matter of adapting to new conditions that include not just credit risk, but the operational risk that we have described.
That transaction also was done without the ECB’s PEPP buying a single bond, because it took some time for the Eurosystem to cover the details of the programme. And this brings me to a wider point: the market is more comfortable in a world in which these measures exist, but these measures don’t have to be used for investors from the private sector to engage.
It’s similar to what happened in 2012: there was just one announcement by the ECB president that made everybody all of a sudden feel more comfortable. So the analogy is a fire extinguisher at a dance floor. It doesn’t have to be used for it to be valuable.
So this is the same with the announcement by the ECB. This is the same with all the European measures. The Spanish Treasury conducted a large auction and a syndication without the ECB or the Eurosystem intervening in any way other than the way it was doing before.
GlobalCapital: So the perception of ECB support is just as valuable as the reality. What about the verdict of the German Constitutional Court — that the ECB must conduct a proportionality assessment for the Bundesbank to continue participating in QE? Are you concerned this will dilute the ECB’s ability to expand its QE and support capital markets?
De Ramón-Laca, Spain: Well, I’m not a German constitutional lawyer, and I’m not even a European law lawyer. But I am very clear on what the ECB mandate is, and on the ECB’s independence.
So I’m not concerned about the continuity of the measures that the Governing Council has decided to use to comply with its mandate. Whether or not the Constitutional Court ruling says something about the relationship between Member States and the EU is a wider topic, but I’m not concerned about monetary policy in itself, because the mandate is clear. The independence is clear. And the communication is clear.
I think the market realises this and this is why there is a lingering concern about the long term, but no concern about the short and medium term as regards monetary policy. I think investors are relatively comfortable with this. We were able to issue a €1.8bn at 30 years in an auction, and the market doesn’t seem to have priced in any uncertainty here.
Whether or not this spells something in the long term is not for me to say, but the capital markets have been reassured by the ECB’s communication.
Post, Belgium: I agree. The market has spoken on this. It might be something for the future, but it’s not something for us to worry about for the moment.
GlobalCapital: Ioannis, people are still confident in the monetary policy of the ECB, and that’s kept EGB spreads under control. But beyond that, do you feel like we’re building up problems of debt sustainability with this extra borrowing?
Rallis, JP Morgan: Potentially, yes, but it depends on a few things which are still uncertain. For example, how big will fiscal deficits really be this year and next year? How fast is the recovery and will the EU agree on ways to help those countries that already went into this crisis with elevated debt to GDP ratios?
And finally, always, maybe most importantly, how will the long term growth and inflation trajectory look in the most affected countries? Right now, the low interest environment and QE running in the background is giving sovereigns a lot of breathing room. But over the long run, we need higher nominal growth rates, exceeding the cost of interest, for countries to bring those debt to GDP ratios down again.
So, to answer the question, I don’t see a concern in the market right now. But over the next 10 years all those questions which I outlined need to be answered.
De Ramón-Laca, Spain: One of the elements behind debt sustainability is how much its debt costs are versus how much it takes in revenue. Debt to GDP is a stock against a flow — a stock of debt versus a flow of GDP. That doesn’t give you the full picture.
Interest to revenue for Spain is 5.8%, the same as in 2004, when the debt stock was three times lower. The level of rates and the average life of a DMO’s debt stock determine how long we can stay like this, because we’ve locked in low interest rates for 7.7 years — a record high. I, as chairman of ESDM, know that everyone has shared in this.
All DMOs have extended the average life, taking advantage of the low rates of the last five years.
We could have saved a lot of money by reducing the average life, but we decided to prepare for just this eventuality. And in terms of stock, yes, stocks are higher, and this is something that we have to finance but it’s nothing to do with the way we’ve managed the economy.
This is a proverbial alien invasion that’s come and this is what debt was invented for. But in terms of the burden of this, in Spain we are at the levels of 2004 when our debt to GDP ratio was 35% and rating agencies had us at triple-A. That’s food for thought as to what determines debt sustainability. Further down the road, the curve could rise and we would be slowly refinancing a very long stock of debt at an increased cost. But so far we have prepared very, very well for just this eventuality.
Post, Belgium: Just to echo this, that has been the strategy for Belgium. We currently have an average maturity topping 10 years. This is the sort of eventuality you build that up for and it makes sustainability much more robust.
GlobalCapital: Countries are facing delays to revenues and are turning to short term markets to finance operational expenditures. There’s been a big increase in requirements in that market. How has it held up for you?
Post, Belgium: We did see a period, specifically at the beginning of April, when the short term market was functioning less well. We had just seen a very strong repricing in the short end market as participants adjusted to the new situation. Also, there was a huge demand for cash, not only from sovereigns, of course, but from everyone.
So obviously there was a lot of selling pressure in all short term assets and that drove prices down quite significantly.
We did feel at a certain moment that there was less depth in the short term market, even after the announcement of the PEPP. We thought it was wise to also include short term paper, but I think there was still some hesitation in the market.
We have seen sentiment change after the latest announcements by the ECB. When Peltro and the new TLT were announced, at that stage we really saw markets rebounding, not just in pricing but more importantly in terms of depth. Clearly the situation has improved.
We’ve had a bit of a difficult patch, which is logical given the context, but the market seems to have been normalizing for a couple of weeks.
GlobalCapital: So we’re over the worst?
Post, Belgium: Yes, although I think in terms of market depth, what we have seen is that the long term markets were already more used to the ECB process, because the buying has been going on there for a longer period. I think the short term market probably has gone through a little bit more stress during this past month, because it was a newer experience for the short term market. It seems to have adapted since the Peltro and the new TLTRO that was announced on April 30.
Casalinho, Portugal: The demand that we attracted for a T-bill auction we held in March was a little bit thin. After the ECB announcements, you could see that demand became much stronger, and not only in terms of the T-bill market, but also in terms of the short end of the curve.
Demand up to the three year area has been quite muted. And since the announcement of the new ECB programmes, the demand has increased quite substantially. We didn’t see significant demand for the 2023 or 2024 bonds before and that’s changed now. The turnover there is also much higher now.
GlobalCapital: What sort of recovery fund do you expect to see from the European Commission?
Casalinho, Portugal: I think we really need to wait for the public announcements to understand what the format will be, and how this recovery fund will be designed. Because what we’ve seen in the past is that the devil is in the details.
Something can look quite attractive but when we start to scratch a little bit beneath the surface, we are confronted with very small features that in the end make the deployment of the facility more complex. That’s why I will wait for the details to be to be announced before forming an opinion.
The European Commission and member states have been able to step up their efforts to curb the crisis, to curtail its impact. The speed at which decisions were made is staggering when compared to the slow pace that we witnessed almost a decade ago. We can only thank our authorities for learning about the importance of acting quickly.
De Ramón-Laca, Spain: The devil is in the details. But these measures don’t have to be deployed in order to be useful. Investors generally feel much more comfortable in a world in which they see that governments understand the nature of this problem, and that they’re making their biggest efforts to ensure that it doesn’t turn into what happened 10 years ago. The market is comfortable there, and we are already deriving value from what has been announced. We don’t have to use it. As I said earlier it is like a fire extinguisher. It doesn’t have to be used in order to be valuable.
GlobalCapital: Ioannis, how does the situation at the moment compare to what we saw in the crises of 10-12 years ago. Have the authorities learned lessons from past crises?
Rallis, JP Morgan: My observation from a capital markets point of view is certainly positive. A lot of the announcements came more quickly, especially in the adjustment of funding programmes. Also a lot of the actors in the market right now have actually experienced a crisis. Most of them were around 10 years ago. I remember when we ran into the crisis in 2008-2011. Most of the people, including myself, had never experienced a real crisis.
But it is different this time. It’s a health crisis first and foremost, although obviously there are economic consequences. When it comes to the public debt and the impact on deficits, it seems this crisis will have a larger impact on the volumes required in order to get through this.
So when we look back at 2010 to 2013, I think the largest long term funding volumes in the euro area sovereign markets in any given year was €850bn. Our own projection right now is that euro area governments will need more than a trillion euros this year to fund and if we include the UK, even €1.5tr.
But we also have to bear in mind, we have the ECB now and we have QE, which is absorbing a lot of this paper in the secondary market. We didn’t have that 10 years ago. So I’m not concerned about the market being able to absorb it but the numbers are certainly a lot bigger than 10 years ago.
GlobalCapital: What about Covid-19 bonds? Are you adding those to your plans?
Post, Belgium: Well, we don’t have any plans to make any use of proceed bonds specifically for this crisis. The Belgian government is always spending a lot of money on social issues, and it’s vital in this crisis in particular. Obviously, a lot of the funding needs come from supporting households and small businesses.
Obviously, there is a very big social component to that. But as we stated in the past, attaching a bond to a specific use of proceeds is not something that we would typically do as a government. We have made an exception for the green bond in order to support that market here in Belgium, and we remain committed to that. We are working on allocation reports for the green bond, but we do not have any plans to add a social layer to that.
De Ramón-Laca, Spain: We don’t have any immediate plans. This is the role of Ico, our development bank. They’ve issued a social responsibility Covid-19 bond and they’ve issued green bonds. They’re a pioneer in social bonds. Like with Maric, we like to think that all of our bonds are social and all of our bonds right now are destined to fight the Covid crisis in one way or another. There would be three reasons to issue a use of proceeds bond. One of them would be to encourage a market and this is why we are willing to do a green bond. Another is for investor diversification. We have yet to be convinced that there are different investors willing to invest in a Covid bond rather than Spanish government bonds. We don’t think that market is well enough developed.
The third reason is communication — to encourage and to show commitment. We are sold on all three of these issues for green bonds because it’s a very long term commitment that the Spanish population has made to ecological transition.
It took us a very, very long time, but we announced that we are willing to do a green bond. Whether or not we do it this year or later depends on, among other things, the budget. We are still rolling over the 2018 budget and there won’t be a 2020 budget, this has already been announced. So when the 2021 budget is announced, we will be able to do a green bond based on this government’s green strategy.
Casalinho, Portugal: We believe that use of proceeds bonds tend to be challenging, unless we want to show a very strong commitment of the government in specific subjects as green or environmentally responsible expenditure. But Covid-19 bonds are not something we are considering. And for us, there is another reason. We have to have a very strong argument to slice up our funding. Our funding needs are not large when compared to Belgium or to Spain.
So, we need to be very careful about dispersing our efforts. So we need to be very focused and our main focus is providing liquidity to our traditional nominal bonds and ensuring a well-functioning market, so if we start dispersing our efforts, we end up with very small, less liquid lines.
GlobalCapital: What about automation and digitalisation? Are these being accelerated by lockdown?
Rallis, JP Morgan: I don’t think the crisis is driving automation particularly fast in primary and secondary markets, because in times of crisis, when working remotely, we want to have an infrastructure in place that is tested. We’re not going to roll out any particularly new equipment that has critical function in operations if we aren’t sure how it’s going to perform.
Obviously, these innovations continue to go on. I have no doubts that in five to 10 years, we’ll be working differently in one way or another. But right now, I’m quite happy that we can rely on a good tested infrastructure for syndications, auctions and secondary trading.
Post, Belgium: I would echo that. I think any big changes are not the first priority at the moment.
Casalinho, Portugal: I agree. People are relying more on the well-tested systems. In the secondary market, during the March and April volatility, on some of the electronic platforms, automatic trading and algo trading dropped off. We’ve seen less of that during volatile times, so the old ways got an upper hand here.