The Counsel

Banking & Finance

Alternative International Financing Options for Pakistan

by Kamran A. Kazim

Head, Corporate and FI Origination, Royal Bank of Scotland

Over the last several months the press has extensively reported on raising international finance through the issuance of OGDCL (Oil & Gas Development Company Limited) convertible bonds. This is certainly one way of raising funds for the country but it has several downsides for the Government of Pakistan (“GOP”), which has not been adequately addressed in the press.

Convertible bonds per se are not the problem. Rather, the problem lies in the opportunity lost whilst issuing these bonds. There are at times hidden costs or giveaways that are not fully reflected in the economics of the issuance and it is only when the underlying conversion option is exercised that the full costs become apparent. Convertible bonds allow the bond buyer to convert all or a certain portion of their bond holdings into equity at a price that, in the event of further price appreciation, may seem inexpensive. Further, OGDCL being the largest Exploration & Production company in the country also has a certain strategic relevance that adds another level of complexity to an OGDCL convertible bond offering. Furthermore, given that Pakistan is still on an IMF program that has had to be extended and Pakistan is struggling with instituting a sales tax reform as required by the IMF this may not be an ideal time for GOP to consider the issuance of convertible bonds. However, there is another option that the GOP may find viable in current global markets and most suitable to the needs of Pakistan - Commodity linked bonds and what follows is a discussion of what they are and why the timing may be right. It is a matter of common knowledge that global commodity prices have been skyrocketing and are expected to continue to increase. This does not mean the rise will continue at the same pace as in the past but what can be reasonably inferred from global GDP growth projections is that industrial commodities such as oil, copper, steel, iron and agri-commodities such as cotton, wheat and soya will experience increasing demand from emerging economies in Asia in addition to the existing demand from G8 countries. China and India alone with over 2 billion people and double digit economic growth not to mention Brazil and Russia (BRICs) will generate tremendous demand for these commodities as their citizens earn a better living and demand more cars, clothing, better meals and all thos commodities that people with increasing disposable incomes seek to purchase. This is what the hedge fund managers and asset managers know and that is why they are investing heavily in emerging markets especially in the energy and commodity sectors. Another reason for this financial trend is that the money managers have access to cheap credit given the low interest rates in the US and Europe, which they invest in commodity related businesses in order to earn superior investment returns. This phenomenon is also referred to as the ‘carry trade’ because low interest rates are carried in one currency and converted into a high risk / high return investment in another currency. This trend is likely to continue as US and European interest rates are likely to remain low given the state of their economies. Moreover, commodity production cannot just be ratcheted up overnight as increased production requires massive amounts of capital expenditure over years. For instance, it takes as long as 12 years to get a copper mine up and running. Hence, commodity price cycles stretch out over several years regardless of the direction of prices and it is likely that high commodity prices will prevail for a few more years before higher production or greater conservation takes effect and prices revert to the mean.

All of the abovementioned factors present Pakistan with a unique opportunity to raise funding in international capital markets. For years Pakistan has been faced with colossal foreign debt and unfavourable terms of trade and low prices of export commodities has adversely affected Pakistan’s ability to service and retire its foreign debt obligations. Pakistan is still, unfortunately, mired in a debt crisis which seriously stifles its economic growth and continues to have adverse impact on two accounts. First, the high debt-service payments require high tax rates that discourage capital formation and the repatriation of capital. Second, since GOP is responsible for making debt-service payments and, those payments appear in the budget, GOP cannot institute a devaluation policy through indirect taxation that could offset and improve our foreign reserve positions.
Although, not a cure for all of Pakistan’s economic ills, commodity-linked bonds do offer Pakistan certain advantages that are seriously worth considering.
Commodity-linked bonds differ from conventional bonds in terms of their payoffs to the investor. The bearer of the conventional bond receives fixed interest payments during the life of the bond and principal at maturity. The principal of a commodity-linked bond, however, is paid in either the physical units of a reference commodity or equivalent monetary value. Similarly, interest payments may or may not be in units of the commodity to which the bond is indexed. Therefore, the structural difference between an equity bond and a commodity-linked bond is that the return of the equity / conventional bond is known with certainty, whereas the return of the commodity-linked bond is uncertain. However, given the high and increasing prices of most commodities today and discussed above, it is likely that most investors will be of the opinion that commodity linked bonds offer better returns than conventional bonds.

Accordingly, GOP should be exploring options for the issuance of commodity-linked bonds. Of course, GOP would need to identify a commodity Pakistan produces whose price and delivery can be linked to an international bond issue. For instance, Pakistan produces cotton, rice and natural gas to name a few. Pakistan can, in fact, even develop a basket of these commodities tied to the bonds. Not only can Pakistan, given the present state of international markets, achieve easier distribution and better pricing for these bonds, commodity-linked bonds also provide an opportunity for Pakistan to hedge against fluctuations in its export earnings. [This is because the repayment associated with a commodity-linked bond decreases as the export price of the underlying commodity and our export revenues decline and vice versa. Quite simply for instance, as the international price of cotton increases Pakistan export earnings also increases leading to increasing foreign exchange reserves. Pakistan will be required to pay out a larger amount in principal and interest on a bond linked to the global price of cotton but the higher amount due on the bonds will be more than offset by our higher earnings and greater foreign exchange reserves. On a net-net basis, therefore, the higher bond payments become irrelevant. Equally, if the price of cotton falls GOP will pay less in principal and interest. Pakistan will only pay more when it can afford to give higher earnings and pay less when it cannot afford to and have lower earnings.]

As for structuring such commodity-linked bonds, an option type of commodity-indexed bond is probably the best suited for Pakistan where interest payments are similar to that of a conventional bond but at maturity the bearer receives the principal plus the option to buy or sell a predetermined quantity of the commodity at a specified price. To minimize a default risk Pakistan can and should retain the option to pay the minimum of the face value of a commodity bond, say USD$1.0 Million, or the value of the reference amount of the commodity at the maturity date, say 100 bales cotton. As is evident, the value of the option -- 100 bales of cotton -- in the commodity-linked bond increases as the price of the commodity indexed to the bond rises. Conversely, the value of the option decreases as the price of the indexed commodity drops. This means that if Pakistan had issued debt contracts with options tied to our main export commodities our debt servicing load would also have declined if our export revenues had decreased. Resultantly, the value of the options in Pakistan’s commodity bonds would have declined and Pakistan would have had to pay fewer of its foreign exchange earning. Moreover, the coupon rate for a commodity-linked bond is generally less than the coupon rate for a conventional bond so Pakistan could raise cheaper funding by sharing the appreciation of the underlying commodity with bondholders.

An example of a developing country, somewhat similar to Pakistan, which has successfully used commodity-linked bonds, is Mexico when it issued Oil bonds in the 1970’s. These were known as ‘Petrobonds’ and each 1,000 Peso bond was linked to 1.95 barrels of oil. The coupon rate was 12.65 per cent per annum and matured in three years. On maturity, the Petrobonds were redeemed at a value equal to the maximum of the face value or the market value of the referenced units of oil plus all coupons received during the life of the bond. With this issue, the government was not only raising new money at low nominal cost but also hedging part of its oil production against fluctuations in oil prices. On the other hand, bearers of the Petrobonds were hoping to benefit from an upswing in the price of crude oil.

It is important to note that the issue of commodity-linked bonds is neither new nor complicated. The use of commodity-indexed bonds dates as far back as 1863, when the Confederate States of America issued bonds payable in bales of cotton to finance its war effort against the Union. The advantages are clear - only by issuing commodity-indexed bonds can Pakistan share the appreciating market value of the commodities it produces with bondholders in return for a lower coupon rate. That could effectively allow Pakistan to borrow at below-market interest rates. More importantly, Pakistan could have placed itself in an advantageous position by being linked to the international markets, such as the U.S. commodity markets and Eurobond markets.

Last, but not least, commodity-linked bonds can also be structured along the lines of Islamic Financing principles. Islamic finance is a growth area especially given the vast amounts of liquidity in the Middle East as oil prices once again surge upwards. Pakistan could have been ideally placed to bring all those Petrodollars to Pakistan given the dearth of Islamic offerings generally. Had GOP developed a well thought out global funding strategy and looked at our options carefully it could have achieved huge gains.

Given global price trends in commodities as well as the high demand for commodity related investment opportunities it is probably wise to consider raising foreign exchange funding in a manner described above. A careful analysis of a commodity-linked bond offering will show that the timing for doing so now is excellent and to the advantage of Pakistan.

The author is an investment banker with 19 years of work experience in New York and London and a graduate of the IBA and Columbia University. He is currently the Head of Investment Banking at the Royal Bank of Scotland Pakistan (recently merged with Faysal Bank Limited). The author is also on the faculty of the IBA. Comments may be directed to

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