Why Ukraine borrows at such a high cost inside the country?
In 2020, the government managed to attract significant amounts of funds from the placement of government issued bonds and reduce the cost of borrowing, even in conditions of high market volatility. However, interest rates on government issued bonds are still too high and market depth is insufficient. This situation is explained by tight monetary conditions, changes in government borrowing policy and low diversification of the investor base of government issued bonds.
Last year, financing through domestic bonds became the most important source of financing the state budget deficit. Gross borrowings from the placement of government issued bonds in hryvnia amounted to UAH 389.2 billion, and government issued bonds denominated in dollars and euros UAH 130.4 billion. The volume of net borrowings in the domestic market in 2020 was the largest for the period 2015–2020, down by a factor of 1.8 compared with 2019 and almost 20 with 2018.
The dominant trends in the government issued bonds market in 2020 were:
1) a remarkable decrease in nominal and real interest rates on government issued bonds in January-July and the resumption of the upward trend in August-December;
2) significant fluctuations in the volume of government issued bonds placement and levels of yields during the year;
3) a considerable rise in the role of banks and legal entities of Ukraine as investors in government issued bonds while maintaining a minimum share of individuals.
The volumes of placement of government issued bonds in hryvnia, the level of their nominal and real yield in monthly terms are shown in Fig. 1. Attractions from government issued bonds in December 2020 became unprecedented for Ukraine and were six times the volumes of December placements in 2018-2019.
Figure 1. Volumes of placement, nominal and real yields of government issued bonds in hryvnia in 2016-2020
Source: compiled by the author according to the NBU
The real interest rate of government issued bonds in hryvnia in January-September 2020 ranged from 3.4 to 6.5% and averaged 5% per annum. This level was twice lower than in 2019. That is, as inflation fell, both nominal and real yields of government issued bonds declined. This was an absolute achievement of the issuer of government bonds. At the end of 2020, however, the real yield on government issued bonds in hryvnia increased again: from 4.1% in October to 6% in December.
The nominal yields of government issued bonds in 2020 generally reproduced the trend of real yields and went down an average of 1.7 compared with 2019. The average nominal rate in 2020 was 9.8% per annum. In the third quarter, the interest rates fell to 8.1-8.9% per annum from 10% in January 2020. But in the fourth quarter, the nominal rates began to rise and reached 11%. The jumps in government issued bonds yields at the end of 2020 were partly due to the general state of public finances and the growing need to attract domestic borrowings. However, the maintenance of high yields of government issued bonds in 2021 cannot be explained by macro-financial factors alone.
With declining interest rates on debt in most countries and falling yields on Ukrainian Eurobonds in international markets (see Figure 2), the increase in government issued bonds yields since November 2020 has to some extent reflected a political component – a change in government policy to establish government issued bonds yields. As a result of such changes and the growth of government issued bonds emissions, the absolute costs of servicing domestic debt in 2020 remained at the level of the previous year (UAH 75.7 billion), although the average level of interest rates on government issued bonds shrank.
- Yields on sovereign bonds of Ukraine, % per annum
- Yields on sovereign bonds of emerging markets, % per annum
Figure 2. Dynamics of market rates on sovereign Eurobonds in Ukraine and emerging markets in 2020 and January 2021, % per annum
Source: Author’s illustration based on data of cbonds.info
In the international context, the current level of interest rates of government issued bonds in Ukraine appears to be inflated, even for a country with a low credit rating. For example, in January 2021, Ukrainian government issued bonds were placed at primary auctions at the following nominal rates: 3-month bonds – at 9.2% per annum, 6-month bonds – at 10.4% , 1-year bonds – at 11.7%.
To assess the acceptability of the current level of interest rates in the government issued bonds market, we used data from the resource investing.com, which allowed us to distinguish the yields of bonds of countries with ratings “B” according to Fitch, S&P and “B2”–“B3” according to Moody’s. The obtained data show that in January 2021, in seven countries with a credit rating similar to the Ukrainian one, the nominal yield on government bonds with different maturities was 6.4; 6.9 and 8.5% per annum. At the same time, similar levels of yields in Ukraine reached 9.2; 10.4 and 11.7% (see table. 1). That is, in Ukraine, nominal interest rates on government issued bonds were higher by 2.8–3.5 percentage points.
Table 1. Nominal interest rates on government bonds in countries with ratings “B” at the end of January 2021
|Average interest rate||6.40||6.90||8.50|
|Deviation of the Ukrainian rate from the average one||2.80||3.50||3.20|
Source: Author‘s calculations
To reduce the inflationary effects, real yields on government bonds in Ukraine and other countries were also calculated. It was found that the average real rate on government bonds with maturities of 3, 6 and 12 months in the sampled countries (except Nigeria) was 2.4%; 3.0% and 3.4% per annum. Such indicators, again, contrast sharply with the level of real interest rates on government issued bonds in Ukraine, which attain 4.2%; 5.4% and 6.7% (see table. 2). That is, in Ukraine real interest rates are significantly higher (by 1.8-3.3 percentage points) by contrast with rates in countries with comparable credit risks.
Table 1. Real interest rates on government bonds in countries with ratings “B” at the end of January 2021
|Average interest rate (except Nigeria)||2.40||3.00||3.40|
|Deviation of the Ukrainian rate from the average one||1.80||2.40||3.30|
Source: Author‘s calculations
In Ukraine in 2020, the cost of attracting government loans denominated in foreign currencies in the domestic market (3.4% in dollar instruments and 2.3% in euros) was considerably lower than the cost of government borrowings in the international capital market: 7.25% in US dollars (except for the December issue at 6.5%) and 4.38% in euros.
Potentially significant demand for government issued bonds in foreign currency is constrained by the establishment of low yields and administrative restrictions set out in the Memorandum with the IMF (Table 1 “Quantitative Criteria and Indicative Targets”). In this way, investors in Ukraine’s Eurobonds receive artificial advantages over domestic investors in government issued bonds in foreign currency, as the interest rate for the first category of investors is 4 percentage points higher. In addition to significant losses to the budget, such policy worsens the balance of payments and negatively affects the external sustainability of the economy.
It is obvious that in the conditions of high prices and unstable access to external borrowings, the government could temporarily increase the issuance of government issued bonds in foreign currency, offering domestic investors a yield of 4-5% in US dollars. Such anti-crisis measure would make it possible to attract foreign currency savings of economic entities as a credit resource for the government and reduce the chronic dependence of state on external borrowing.
It is also surprising that during the period of high interest rates on government issued bonds, which began in December 2020, the government began to actively place long-term government issued bonds at nominal rates of more than 12% per annum. Although under the principles of sound financial management government losses from high rates should be minimized through the placement of mostly short-term bonds. Such securities could be refinanced at a lower cost in the future after the end of the high interest phase. However, this principle, unfortunately, is ignored in Ukraine.
The structure of the base of investors in government securities in 2020 underwent the following significant changes: the share of Ukrainian banks grew from 40.6 to 51.9%, and legal entities – from 3.2 to 5.8%. At the same time, the share of the NBU was reduced from 41 to 32.7%, and the share of foreign investors – from 14.1 to 8.5% (Fig. 3).
Figure 3. The structure of the base of investors in government issued bonds in % as of begin and end of 2020
Source: compiled by the author according to the NBU
The amount of government debt to foreign investors in January-November 2020 decreased by UAH 41.1 billion, and in December, by contrast, increased by UAH 9.7 billion. In January-February 2021, non-residents’ investments in government issued bonds went up by UAH 17 billion. Thus, foreign capital inflows into government issued bonds over the past three months are already approaching USD 1 billion. The decline in the presence of non-residents for 11 months was explained both by the fall in interest rates on government issued bonds and the decrease in the risk appetite of investors. And since December 2020, have increased, not least due to higher interest rates. Foreign capital inflows in the government issued bonds market inevitably affect exchange rate fluctuations and budget sustainability.
In 2020, investments of individuals into government issued bonds increased by UAH 1.4 billion, but amounted to only 0.3% of GDP. In the measurement of international comparisons, this level of participation of individuals is very low. According to Eurostat, in Latvia and Lithuania the figure reached 0.5% of GDP, in Poland – 1%, in Italy – 5.1%, in Ireland – 6.8%, in Hungary – 14.5%, in Portugal – 15% of GDP. In Ukraine, this situation is accounted for by high transaction costs for the acquisition of government issued bonds and dubious requirements for investors in terms of financial monitoring.
Banks of Ukraine, on the contrary, expanded their portfolio of investments in government issued bonds by UAH 180.1 billion to UAH 514.4 billion. Such increase was mainly due to government issued bonds in hryvnia, investments in which grew by UAH 162.7 billion.
The jumps in interest rates, the volume of placement of government issued bonds and the change in the weight of different categories of investors largely reflected the processes both in the public finance system and in the monetary sphere of Ukraine. In 2020, the NBU pursued a rather tight monetary policy and denied the possibility of “quantitative easing”, which was a significant factor in keeping inflated interest rates in the government debt market.
And this is at a time when, even in 2021, IMF experts recommended continuing to provide support to economies from fiscal and monetary policies and do so until the economies take a steady rise.
The asset purchase program by the National Bank (including government issued bonds) could be a major lever in restoring the normal market yield curve, curbing the growth of the value of borrowings and improving public finances with limited government access to market financing. It could have happened, but, unfortunately, it did not, unlike 20 emerging market economies, in which such programs have been successfully implemented since 2020.
Given the identified problems, the important tasks in the field of monetary and fiscal coordination, in my opinion, are the resumption of NBU operations on the sale and purchase of government issued bonds on the secondary market, elimination of undesirable competition for government issued bonds from NBU certificates of deposit, overcoming regulatory barriers for banks to invest in government issued bonds in foreign currency, increasing the interest of individuals to invest savings into the government bonds.
In 2021, the government aims to continue the active policy of government borrowing and attract UAH 497.3 billion to the budget from the government issued bonds market. Given the state of the national economy and health care, such policy is quite reasoned. According to the IMF, although debt problems are relevant to many countries around the world, the more urgent task today is to avoid premature termination of fiscal support for the economy; such support should continue until at least the end of 2021 and ensure that the economic recovery process is fueled and the destructive effects of the pandemic mitigated.
Therefore, in Ukraine, as in many countries throughout the world, in 2021 it is necessary to continue the policy of stimulating economic growth through the provision of state aid to viable enterprises, large-scale financing of investments, social support for vulnerable groups. Incentive fiscal policy undoubtedly requires adequate sources of financing, including domestic borrowings. But the maximum use of the potential of the government issued bonds market is impossible without overcoming the problems outlined above and minimizing the existing risks.
Scientific Director at the Growford Institute, Doctor of Economics Tetiana Bogdan for “Dzerkalo Tyzhnia”.