The influence of tax regulation liberalisation on the development of the domestic debt market

Having opted out of the inflationary financing of the budget deficit, Russia began developing the domestic market of government securities in 1992-93. In 1995, more than 50% of the budget deficit were financed by issuing government bonds, and the inflation rates decreased from more than 1000% (on a year-on-year basis) to 160%. Against the background of a certain economic stabilisation, there was an extension of the real sector crediting and improvement of social indicators. Nevertheless, preservation of a very liberal budget policy and low fiscal discipline was increasing the load on the domestic debt market. Shortage of the resource base was partially solved by admitting non-residents to the domestic market, but unfolding of the Asian financial crisis during the second half of 1997, petroleum price downturn and capital outflow from the developing countries uncovered the frailty of the Russian finance-budget system, having led to its meltdown, eventually.

After 1999, Russia had a high surplus of budget and foreign trade balance and did not bother to reform the domestic market for using it in a new capacity, having aimed at decreasing the general debt burden instead. Growing needs of the real sector under conditions of the recovering economy stimulated rapid development of private bond market while federal loan bond market had low priority. By the middle of 2008, outstanding amount of the corporate bond market exceeded 2,0 trillion roubles, i.e. twice as much as that of the federal loan bond market, while the average monthly turnover exceeded the values of the government bond market 30 times.

“Tectonic” changes in the global finances in the autumn of 2008 have led to a significant contraction of the credit markets worldwide, limiting the ability of many countries to raise capital outside their local markets. Reconsider its own attitude to external risks, and having realized the potential benefits of the well-developed domestic market, Russia began its modernization:

· Increasing transparency of own operations, the Ministry of Finance resumed mid-term planning in 2010 and proceeded to publishing the quarter lending plan.

· The Ministry of Finance has refused from selling bonds on the secondary market and thus increased the importance of the primary market in the eyes of investors, as well as credibility of the issuer.

· Use of a well-known practice of publishing price guidance before the bond auction has increased the attraction on the primary market.

· Amendments in The Central Bank’s Regulation “On servicing and trading of issues of federal government securities” have repealed requirement for preliminary depositing of the money before auctions, thus, increasing the flexibility of investors’ operations and their interest towards the market.

· Since the beginning of 2012, the operations with the government bonds on the OTC market have become available. Having extended the possibilities for managing the portfolio of government and non-government bonds, this has also attracted the investors and increased market liquidity and capitalization.

· In 2011-12 The Ministry of Finance proceeded to practice to sell the benchmark bonds with standard maturity terms that, due to their high-liquidity, have become representative indicators of the cost of credits with different maturity dates.

· Starting from November, 2012 г National Depository Center began to function as Central Depository, and from February, 2013, the international clearing-and-settlement systems Euroclear и Clearstream got an opportunity to open fiduciary accounts and service international investors’ transactions on the federal loan bond market without opening a securities account in Russian broker companies. In result, The Ministry of Finance has broadened the base of the holders of government bonds to fulfill the State borrowing program.

Implemented conversions have significantly changed the landscape of the whole domestic debt market: its capitalization has increased 3,5 times, and The Ministry of Finance has obtained the possibility to borrow up to 15 years, and, even more important – in roubles under the domestic legislation. The borrowing costs have decreased by 7-8% even for such a long terms. The market has become an effective tool of The Bank of Russia’s monetary policy and representative benchmark for corporate and regional issuers. The interest of foreign investors in the Russian domestic bond market increased significantly, while their market share increased from 5-7 to 25 percent over 3 years. The net volume of fund attraction in the budget (with account of expenses on debt servicing) reached the amount of 780-830 milliard roubles in 2010-12.

Meanwhile, having been integrated into global markets, Russian domestic market became more vulnerable to external shocks than in early 2000-s when it reacted to oil price and to The Central Bank’s statements on the international reserves changes. Budget and debt crises in Greece, Spain and Portugal in 2011-12 led to global markets fall. While the Russian government bonds yield increased along the curve, the Ministry of Finance capability to raise funds in the budget were significantly limited. In May, 2013, Head of US Federal Reserve announced the possibility of the high-accommodative monetary policy changes, which triggered a more serious meltdown of the developing markets. Growing geopolitical tension, cooling in relations between the Russia and the West, triple downturns in oil prices and rouble devaluation were accompanied by non-residents’ outflow from the Russian government bonds market. The five and ten-year bond’s yield skyrocketed to the 16,0-17,5% level late in 2014 year from 6,0-6,5% in April-May of 2013.

Figure 1. Profitability dynamics of 5 and10-year federal loan bonds from 2011 to 2015, %

Source: Bloomberg

The domestic debt market indicators have seriously degraded both qualitatively and quantitatively: the market outstanding amount has decreased, yields has doubled, while the Ministry of Finance net financial result was negative in 2014 [1] (including the volume attracted and the debt-service expenses).

Table 1

Some indicators of Russia’s federal budget implementation as for the state domestic loans

Year	OFZ markets amount outstanding, billion roubles.	Attracted at the primary market, billion roubles.	Ministry of Finance net financial result, billion roubles.	OFZ’s weighted average yield, %
2008	1,144.0	160.9	88.2	9.1
2009	1,469.7	426.9	326.8	8.6
2010	2,054.2	728.6	499.8	7.4
2011	2,803.3	760.9	889.0	8.1
2012	3,296.7	811.0	267.2	7.0
2013	3,734.8	829.0	77.8	7.5
2014*	3,589.6	252.6	-283.4	14.6

Source: Russian Ministry of Finance, calculations performed by A. S. Ovchinnikov

* exclusive 1 trillion roubles, which the Ministry of Finance has attracted by the long-term bonds issue in the purpose to some banks recapitalization.

According to the BIS (Basel Bank for International Settlements), the volume of dollar-denominated debt issued by the non-bank borrowers outside the USA has exceeded $9 trillion [2] compare to $6 trillion in the beginning of 2010. The highest gain has been noted in the corporate bonds sector on the developing markets in response to growing supply of cheap liquidity by US Federal Reserve and growing demand for high-yielding assets on the part of investors. In combination with dollar strengthening, the beginning of the cycle of rate increase by US Federal Reserve poses serious risks to financial stability and can eventually result in emergence of new crises in the nearest future.

After having been isolated from the western capital markets in 2014, Russia has partially discharged its debts (the amount of foreign debt has decreased from $729 to $599 billion), thus, improving the country’s macroeconomic indicators (well-timed). At the same time, having suspended the reforms and relied on long-standing high oil prices and ongoing inflow of international investors’ money, The Ministry of Finance had to cancel 22 auctions in 2014 and attracted only 253 billion roubles from the primary market and repay 574 billion roubles. As a matter of fact, the State borrowing program was fulfilled “successfully” only thanks to occasional need for issuing government bonds in the amount of 1 trillion roubles for the purpose of recapitalization of the banks.

Counting to attract from 700 to 800 billion roubles to the budget in 2015, the Ministry of Finance will have to repay the principal amount for 622 billion roubles and for interest – 257 billion roubles. In order to solve this problem, the Ministry of Finance has allocated medium-term (five-year) floating rate bonds linked to the RUONIA rate. Having offered the securities with term to maturity mainly from 1 to 5 years in the first two months, the issuer was able to attract only 51 billion roubles, which is three times less than its obligations to repay in the first quarter. In case the preliminary plan to borrow up to 800 billion ruble in 2015 year are fail, it is possible that the Ministry of Finance will once again use the tried-and-true procedure to issue non-tradable securities, for instance, saving bonds. Still it is clear that neither shortening of duration, nor non-tradable illiquid bonds have nothing to do with well-developed market.

Under conditions of changing monetary policy of the US Federal Reserve, established and deepened imbalances in the development of various world’s regions, it is necessary to accept the fact that the conditions on the developing markets will not be so favorable in the nearest future as they used to be. In particular, for the Russian State budget and companies these conditions will be aggravated by the current political environment and the presence of sanctions that are likely to preserve longer than predicted. These conditions drive to performing strategic development of the domestic market through qualitative reforms:

1. Taxation regime revision. The taxation regime in force (15% per interest income and 20% - on capital gain) was first introduced in January, 1997, and was adequate to the interest rates level, market structure and the character of operations. High taxation rates at that time were compensated by low funding costs in the Central Bank (about 2,5-3,5%). Today the cost of funding of the interbank market and in the Central Bank has considerably changed. During the 90-s market duration was less than one year, the average yield level – about 25%, and the character of operations was mostly speculative (by nature) and, apparently, taxation thereof was an adequate measure. Over the last years, the character of investors’ operations, including the Russian ones, has undergone considerable changes. It can be expected that that the decrease of tax rates will entail reduction of debt holders’ expenses (especially, when it comes to long-term debts) and also will stimulate the demand and terms of bond-holding in the investor’s portfolio. Establishment of a flat tax rate regime will simplify calculation and payment of income taxes as interest on government and municipal securities, since they will be included in the calculation of a unified database of calculation per income.

2. Development the bond auctions schedule. The experience of developed markets and the history of the domestic market of government securities evidences that liquidity is not evenly distributed among all the issues on the curve, but rather is concentrate in several points. As a rule, these are the issues of 2-, 3-or 5-year bonds in belly of the curve, as well as long-term bonds with maturity dates of 10, 15, 20 and 30 years. These securities are the most liquid ones, they enable hedging the interest risks with use of the instruments of a derivatives market and debt market, also the standard terms. After several months the old (off-the-run) issues are replaced with the new ones (on-the-run), with the exact observation of maturity dates.

Thus, until 2014, 5-6 most liquid issues with more or less standard maturity dates constituted from 60 to 90% of the secondary market turnover of federal loan bonds on the Russian market. As practice has indicated, securities became liquid after 30-40% of the issue volume had been placed on the market. Still, in most cases it took half year or more to achieve this. By that time the bonds stopped being the ”standard term” instrument. Thus, 5-year federal loan bonds-25081 (maturing in January, 2018) whose placement began in the beginning of February, 2013, were regarded on the market as 4-year bonds after half year.

3. Formation of Primary dealers. Usually, placement of benchmark issues is closely related to the introduction of a specialised group of professional market-makers. In practice we can see successful examples of issuers’ interaction with Primary dealers selected from most active professional participants. In result of applying such an approach and using Primary dealers as market-makers on the secondary markets, the efficiency of the Ministry of Finance’s borrowings on the primary market will considerably increase while market risks born by regular investors will considerably decrease.

Competitive environment and possibility of losing this status will be a natural incentive for Primary dealers to maintain their broad presence on the primary market and to sustain quotations on the secondary markets in competitive spreads and volumes. The structure of Primary dealers have to be revisited from time to time – the least proficient ones should drop out.

4. Development of new instruments. Having an infrastructure that is still weak, the Ministry of Financeу cannot stake on a constantly high demand on the part of investors whose possibilities are still limited. The experience of world’s financial centres demonstrates that a number of countries are bent on creating attractive conditions for the investors on the domestic capital market. The success story of the STRIPS program in USA, Canada, France, Germany and other countries, including Asian ones, has proved to be highly efficient, increasing attractiveness of the basic market of government securities. Ensuring the flexibility of strategies of managing risks and portfolios, this program maintains the interest of investors and forms a firm basis for government lending even in the periods of stabilisation and interest rate growth.

Application of a similar program in the Russian Federation will increase the attractiveness of the domestic market of government securities by creating conditions for the development of capital intensive and liquid domestic market. It will increase the attractiveness of investments in the rouble-denominated instruments, thus, strengthening investors’ confidence in rouble as a hard regional currency.

I believe that the above-stated measures will facilitate the development of a strategic approach to the formation of a deep and capital-intensive domestic market of government securities whose susceptibility to external factors will decrease. This will help to break the vicious circle of “workarounds” in response to each newly emerged external change and will also help to develop Russian domestic market, which is very important from the perspective of budget- and monetary-policy and national economy, in general.

[1] Exclusive of the emission of non-market issues of federal loan bonds for additional capitalisation in the amount of up to 1 trillion roubles

[2] «Financial stability risks: old and new», Presentation by Mr Hyun Song Shin, Economic Adviser and Head of Research of the BIS, at the Brookings Institution, Washington DC, 4 December 2014.