Sovereign debt

Exclusive: Philippines' treasurer on how the country is inching towards the A-grade rating

The country's national treasurer explains the government's action plan to facilitate a sovereign rating upgrade to the coveted A status. Prioritising domestic debt fundraising over international and expanding its product mix to include sukuks and green bonds are part of the answer.
The Philippines spent more than two decades with a sovereign credit rating that remained firmly stuck at the BB level. One thing the country does not want to endure is the same time period again at the BBB level.

The government has its eyes firmly set on an A-rating and in some respects investors clearly believe it is already there based on tight secondary market trading levels. 

The ratings agencies have also been moving in the same direction ever since Fitch became the first international agency to put the sovereign in the BBB bucket back in 2013. On February 11, it lifted the outlook on its current BBB rating from stable to positive.

One year ago, S&P also lifted its BBB+ rating by a notch and assigned the sovereign a stable outlook. Right now, it is Moody's bringing up the rear given that it has not acted on its Baa2 rating with stable outlook since December 2014.

In the following interview, the country’s treasurer, Rosalia De Leon, explains how the government is improving its fiscal metrics to boost its chances of securing more positive ratings momentum. She also discusses plans to widen the Republic's fundraising options by diversifying into sukuks and green bonds.

Q. You traditionally access the dollar markets for your first benchmark of the year. Why did you decide to target euros this time instead?

A. We decided to proceed this way because of the favourable market conditions in the euro market. These allowed us to achieve a zero-coupon bond for our three-year paper and lock in low financing costs. 

We also wanted to capitalise on the strong demand from this space, where investors continue searching for yield amid a negative interest rate environment. It allowed us to increase our issue size to Eur1.2 billion ($1.3 billion) and tighten pricing to 40bp and 70bp over the benchmark for the three- and nine-year bonds, respectively.

Q. Can you explain your pricing strategy for this bond and what you feel you achieved?

A. The Philippines can price bonds tighter than similarly rated and even some higher-rated peers because volume isn’t a top priority and our credit is backed by solid macroeconomic fundamentals. 

Our strong bias towards domestic funding sources also allowed us to prioritise price over size. This ultimately contributed to the historic zero-coupon on the three-year bond. We’ve since swapped out the euro proceeds for cash management purposes.

Last year’s euro market deal helped this year’s issue as European investors were already familiar with the Philippines’ credit. And while we did see investors from our previous eight-year issue come into the new nine-year, we also observed new pockets of investors come into the shorter tranche.

Q. What’s your view on your current credit rating? The government has previously said it deserves an A rating, but why?

A. The Philippines is already implicitly rated “A” if it’s based on our bonds’ tight pricing and CDS performance. However, there are stumbling blocks we need to hurdle in order to reach the sterling A status when it comes to our official rating.

Firstly, we need to sustain rapid GDP per capita expansion as this has a substantial weighting in the major credit rating agencies’ methodology. This is why we’ve been investing heavily in infrastructure modernisation and making our workforce more competitive through free education and social health care.

Secondly, we need to improve revenue uptake to support a larger budget for infrastructure and social services. Our revenue-to-GDP ratio is still below the median for rated-A sovereigns. But we’re quickly catching up following the enactment of package 1 of our Comprehensive Tax Reform Programme.

We expect to close the revenue gap in just a few years given that the passage of the remaining tax packages is targeted within the year.

Finally, we’re also anticipating improvements to our governance scores in the World Bank’s Worldwide Governance Indicators (WGI). These also form part of the rating agencies’ criteria.

Some of our recently implemented initiatives haven’t been incorporated into third party data contributor reports for the WGI yet. These include the Rice Tariffication Law and the Anti-Red Tape Act. Hence, we’re likely to receive higher institutional and governance scores once they are reflected in the data.

Q. How much do you plan to raise from the international bond markets this year and what ratio are you targeting relative to peso issuance?

A. We are targeting $3.7 billion from international issuance including the euro, US dollar, Japanese yen, Chinese renminbi, and the Swiss franc markets. We view these as reliable funding sources: all the more conducive because the sovereign has already established its reputation and credit in them.

The plan is for a financing mix of 75% from domestic sources and 25% from offshore. This represents an adjustment from the previous 70:30 ratio.

It's in line with our target of increasing our reliance on the domestic debt market, particularly to support the funding requirements of the administration’s “Build, Build, Build” infrastructure programme.

But we’re still cognisant of the conducive borrowing environment from external sources and the possibility of tapping the international debt capital markets. But the increase in onshore funding also ensures that we get more cost-efficient funding and currency risks are averted.

Q. What steps is the government taking to improve the attractiveness of the domestic bond market for foreign investors?

A. We’ve undertaken several domestic market reform initiatives precisely to improve GS trading liquidity and make them more attractive to both onshore and offshore investors. The main imperative is to have a system whereby primary dealers are obliged to provide two-way quotes for buyers and sellers so that investors can easily move in and out of their GS positions regardless of the market environment.

Several steps have already been taken. This includes the Repo Programme, which has introduced a Global Masters Repurchase Agreement (GRMA) based market system for repo transactions.

Then there is the Enhanced Government Securities Eligible Dealer (GSED) Programme. A few GSED participants have been awarded exclusive privileges and obligations, as a precursor to a full primary dealership system.

This has been complemented by our transition to the Bloomberg Valuation Service (BVaL) methodology for the calculation of our yield curve. This has eliminated some of the inefficiencies and vulnerabilities of the old methodology.

Since the transition to BVaL, we’ve been able to create a smoother and less jagged yield curve. To improve on this further, we’re looking at the introduction of STRIPs for our GS market.

Lastly, we’re aligning the taxation regime for fixed income securities with the rest of the region via package 4 of the Comprehensive Tax Reform Programme. This will lower foreign investors’ withholding tax on interest income from 30% to 15%.

A 15% withholding tax on interest income will make our bonds more competitive vis-a-viz other regional fixed income markets. When combined with the strength of our economic trajectory, this may pave the way for increased foreign participation in our local currency bond market.

Q. Do you think there is an optimal foreign holding of domestic bonds?

A. In 2019, offshore participation in our GS market only ranged between 4% and 7%, so there’s definitely scope to encourage increased foreign holdings. A higher foreign participation rate will enhance our ability to source a larger proportion of the funding requirement in our local currency, thus reducing our exposure to foreign currency risk.

Moreover, it will also diversify our investor base, providing more stability for the local bond market. This will be especially noticeable during periods when local players tend to move in one direction such as 2018 under a rising interest rate environment. 

However, there’s also recent evidence that an excessively large level of foreign participation can become disadvantageous as foreign players may demand higher liquidity premia, increasing a government’s cost of borrowing. A 2019 Federal Reserve paper by Christensen, Fischer and Shultz examined what happened in Mexico during 2019. 

Therefore, the Philippines will proceed cautiously in raising foreign participation, ideally gradually from the current 5% level.

Q. A number of Asian sovereigns have now issued green and sukuk bonds. Is this something the Philippines is interested in doing?

A. We see a lot of opportunities in the green and sukuk space in terms of diversifying and expanding our investor base as well as increasing our presence among foreign portfolios globally and meeting the administration’s ESG initiatives. 

In the green bond market, the Philippines Securities and Exchange Commission (SEC) has adopted the ASEAN Green and Sustainability Bond Standards to increase green issuance. Since its implementation, there have been 15 bond offerings from companies and banks out of the Philippines, totalling $3.04 billion. There have been notable deals from government financial institutions, private banks and energy companies.

We see strong investor demand especially from institutions with allocated green investment funds. Local issuers have also become increasingly familiar about green bonds. With liquidity building up, we are exploring opportunities to issue sovereign green bonds in the future.

In the sukuk market, the government is actively exploring approaches to issue a maiden deal. There’s been a lot of progress and we’re currently engaging with key agencies with regards to the right issuance framework, tax neutrality treatment and other relevant regulations.

A significant chunk of the Philippines’ population is Muslim and may feel constrained about participating in conventional banking and investment activities because of certain prohibitions like riba or charging interest. A sukuk issue could play a key part in the government’s financial inclusion initiatives to address this gap.

In recent local developments, the Republic Act No. 11439 or “An Act Providing for the Regulation and Organization of Islamic Banks” was signed into law last August. This aims to unlock the full potential and promote inclusive economic growth. An inter-agency working group on Islamic Banking and Finance has also been set up to develop a regulatory framework.

Q. What’s your view on general offshore market sentiment right now?

A. Recently, market sentiment seems to be in yield-seeking mode with investors hunting out yields to put their money to work. However, US elections, Brexit, and the Olympics lurk around the later part of the year, causing a lot of uncertainty during that time.

The US-China trade war seems to be moving in a positive direction, but the outcome remains to be resolved. The novel coronavirus outbreak is also currently causing trade and travel disturbances in Asia and dampening China’s GDP.

Experts don’t expect sustained damage to the financial markets, assuming the outbreak is contained over a similar timeframe to the 2003 SARS outbreak. Market sentiment should be able to recover quickly as Asian market technicals stay strong.

Q. Investment bankers we spoke to all mentioned how strong domestic liquidity is and the number of new private banking products coming online. What impact will this have on domestic funding conditions in 2020?

A. For this year, we expect a continuation of the generally favourable funding condition we experienced in 2019. Indeed, there’s been a build-up in domestic liquidity, thanks in large part to a 400-percentage point cumulative reduction in the reserve requirement ratio, which the Bangko Sentral ng Pilipinas (BSP) implemented last year. 

So far, our regular Government Securities (GS) auctions have achieved average 1.8 times bid-to-offer ratios. There was overwhelming demand for our recent Retail Treasury Bond offering as well. As a result, we had to cut the offer period short as we’d already reached P250 billion ($4.9 million) in new subscriptions, one of the largest-ever through the retail format. 

The market’s also had little difficulty absorbing numerous debt offerings from private sector issuers during the same period. This includes jumbo issues from BDO (P40.1 billion) and BPI (P15.3 billion).

Q. The domestic yield curve has been steepening. Do you see this continuing and, if so, why?

A. The Fed’s forward guidance is indicating a steady policy rate environment in the US for 2020. So, the remaining market imperative for yield reduction will be BSP’s action on its policy rate and reserve requirement ratio.

Hence, it was no surprise when yields initially climbed during the opening weeks of the year. A spike in crude oil prices and the eruption of the Taal volcano threatened inflation, the principal basis of the BSP’s rate setting.

However, as we’ve observed in more recent auctions, this trend has since reversed as crude oil prices normalised and Taal’s volcanic activity receded. For the rest of 2020, we expect rate movements to be heavily influenced by inflation outcomes. And we expect this to remain within the middle of the BSP’s 2% to 4% target range.

Moreover, we expect the economy to grow faster: by at least 6.5% this year. The timely budget approval and conclusion of the Phase 1 trade deal between US and China has resolved some of the major impediments to growth we encountered last year.

 

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