As outlined in Uzbekistan’s New Development Strategy 2022-2026, President Shavkat Mirziyoyev has called for a radical transformation of the economy. Judging from recent media coverage and on-the-ground appearances, Uzbekistan is well on its way in meeting its socio-economic development objectives.
That’s all good news, but Uzbekistan can do better.
It is high time for Uzbekistan to start developing a deep long-term debt capital market in som, the country’s currency. To accelerate the process of economic transformation, a well-developed local debt market would serve Uzbekistan’s lenders and borrowers better than the current structure of its debt markets, and in time would even better serve foreign investors.
The main reason the som-denominated bond market remains underdeveloped is that loans in som are expensive because of inflation; Box 1 illustrates why a part of the som debt market, under current conditions, isn’t attractive to borrowers.
Box 1: Who can afford a 16% mortgage in Uzbekistan?
To explain the purpose of this article, consider the home-loan market in Uzbekistan. If you want to buy a house, you can take out a som mortgage loan with a bank at a rate, currently, of 16%. For a 20-year linear mortgage, a 5% redemption per year, implies that the borrower pays the first year a total of 21% of the original amount. Who can afford that?
This helps explain why in Uzbekistan the average mortgage on a house is only 25% of the value of the property. Banks appear to be shortsighted.
A far better product for the banks is an inflation-linked mortgage. Assume the inflation will be 12% next year, and assume the bank wants to make 4% margin. What would the borrower pay? The borrower would only have to agree to 4% interest, plus inflation.
Roughly, the borrower will pay in the first year the 4% interest plus the 5% redemption, which totals 9%, plus inflation over this amount which will be 1.12 times the 9% or about 10%. So. in the first year, the bank charges the borrower only 10% instead of the original 21%. The mortgage has become twice as affordable!
Stated differently, with an inflation-linked mortgage, a person can borrow twice as much. As such, the average mortgage in Uzbekistan could now easily jump from 25% to 50% of the market value of the house.
The solution to the relative unaffordability of the som debt market is to develop som-denominated inflation-protected debt instruments. Instead of a nominal rate of, say 16%, the borrower now would pay only a risk premium, of say 4%, each year adjusted for inflation. In our example, in the first year, the borrower would pay half of the cash flow compared with the amount payable for a loan in today’s market.
There is no magic, here as with inflation over time a borrower’s payments increase in nominal terms, and you end up paying the same as you did under a traditional (non-indexed) contract. The difference is that the cash flows are, in real terms, better distributed over time.
When pricing inflation-indexed instruments, the uncertainty of Uzbekistan’s future inflation is factored out of the calculation. Even long-term maturities of 20 or 30 years should be possible.
Since the risks are lower, it can be expected that this type of debt will lower the cost of borrowing in Uzbekistan, which will not only serve the government’s budget, but encourage investments in the country as well; the housing market (see Box 2) would also benefit.
Box 2: Economic theory predicts that an inflation-linked bond offsets currency risk, namely, the local currency’s purchasing power at maturity remains the same in any market. In other words, the exchange rate between two countries is effectively in equilibrium.
Inflation-linked bonds are designed to make prices and inflation irrelevant because the purchasing power of principal and interest at any time is supposed to be the same across markets. It doesn’t matter, for example, if an asset today costs US$1,000 or $10,000 in six months’ time because you receive the relevant amount at any time irrespective of its nominal cost.
Long-term bonds in local currency
To give another example of the usefulness of the development of a local bond market, consider Uzbekistan’s government borrowing needs as articulated by its Ministry of Investments, Industry and Trade.
It is clear that Uzbekistan needs long term financing as there is no dearth of infrastructure projects with long shelf lives, such as the ambitious Trans-Afghan Railway, not to mention its planned free economic zones and public private partnerships (PPPs) across the country.
Since these projects are very capital intensive, it takes a long time to pay them back. A railroad’s borrowing costs cannot be “earned back” in only three years, and therefore should not be financed on such terms.
A debt crisis could be knocking at the door if Uzbekistan aims to finance its long-term commitments with debt instruments that must be refinanced every three years. Long-term foreign-currency borrowing has similar drawbacks, since exchange rates are outside Uzbekistan’s control.
What’s more, these projects are best financed in local currency, as they are in Uzbekistan.
Uzbek Treasury Inflation-Protected Securities (TIPS)
To finance these projects, Uzbekistan should develop its TIPS (treasury inflation-protected securities) market, inflation-linked local-currency debt instruments or Uzbek Treasury Inflation-Protected Securities (U-TIPS).
Like US TIPS, U-TIPS could be indexed to a reliable inflation metric to protect investors from a decline in the purchasing power of their money. How TIPS work is that the principal value of a TIPS rises as inflation rises, and for that reason, the coupon payments adjust proportionally.
Importantly, Uzbek TIPS would allow investors to focus on the credit risk in the capital structure and, accordingly, price the bonds more in line with credit default swaps. Credit default swaps are instruments that only price in the costs attached to default and in theory ignore other risks like inflation.
As an example, Turkey recently issued a 10-year bond at 27% per annum while its credit risk was priced at only 7%. Instead of issuing a 27% bond, Turkey should have been able to issue a TIPS in the range of only 7%, that is, investors receive an annual return of 7%, each year adjusted for inflation.
Moreover, an inflation-linked bond is the better structure compared with a fixed-rate long-term bond for the following reasons as well:
- Lower risks: more certainty for both lender and borrower about the real income and cost of debt.
- Lower borrowing costs because of lower risk premium as inflation risk is hedged.
- Local currency risk largely avoided due to inflation hedge. The longer the borrowing term the more this will be true (see Box 2).
- Foreign-currency risks avoided, such as eurozone inflation or EU single-market imbalances.
- No foreign political risks such as sanctions on dollar payments to third countries.
Other advantages that accrue to a country from developing a robust local-currency government bond market include:
- A more stable financial system with Uzbekistan in control (better allocation of savings) enabling companies to raise domestically sourced long-term funding.
- Better management and planning of government budgets (limit the need to sell strategic assets, raise taxes, or overload the central bank’s balance sheet).
- Helps fix a benchmark rate for government risk and domestic financial markets.
- Stimulates local private capital markets and provides investment opportunities for local pension funds and insurance companies.
Mirziyoyev might consider calling on his financial team to put together a plan to develop the mechanism – including a credible and independent methodology to measure inflation – to issue inflation indexed local-currency debt instruments with 10-year tenors, and even longer.
In this way, Uzbekistan would join Japan, South Korea, and a handful of others as the only other country in Asia to issue 10-year inflation-indexed bonds.
Source: Asia Times