Debt Investors in Ukraine Are Leery of Regulations
May 17, 2011
KIEV, Ukraine -- Investors in Ukraine's high-yield Treasury bills cheered the central bank's decision last week to peg the country's new national currency to the dollar. But while analysts say the move goes a long way toward protecting nonresident buyers from currency exposure in this volatile pre-emerging market, they grumble that unresolved issues over Ukraine's murky tax code are driving many potential buyers away. The introduction of the hryvna, as Ukraine's new legal tender is called, has capped a period of unusual macroeconomic stability here that brought soaring returns to gutsy investors who gambled on Ukrainian fixed-income government securities. With yields on three-month discount paper topping 100% in June, many have cashed in big on this summer's near zero inflation and currency stability. Interest, but Caution ``There's been a tremendous surge in interest among Western investors during the past two months,'' says Backus Lawhorn, an analyst at European Privatization Investment Corp., an Austrian investment bank. ``But no one's made a big splash yet because of uncertainty over getting out,'' she said. One of the main sources of confusion is tax rules. Under current regulations, profits on government securities are tax exempt if the script is held to maturity. But if sold on the secondary market before redemption periods, returns can be subject to a 30% capital-gains levy -- although it is unclear if the levy applies to state debt. While many bankers in Kiev openly brag of skirting the tax, few serious Western investors say they are willing to risk similar maneuvers. Moreover, a 15% withholding tax and Ukraine's lack of double-taxation treaties with many Western countries can leave some investors in for a nasty surprise when they repatriate profits. ``There needs to be a codification and uniformity of taxation policy'' concedes Schofield Brogan, head of the central bank's capital markets and exchange department. The lack of clear rules, grumble bankers, has crushed liquidity, restricting most investors to buy-and-hold positions. Deficit Funding For Ukraine, the stakes are high. Treasury bills are a crucial source of funding budget deficits without fueling inflation, which raged at a crippling annual rate of over 10,000% only two years ago. For the government, continued growth of the bond market is also an essential lending requirement for outside donors like the International Monetary Fund to keep disbursements flowing. And, according to former Deputy Prime Minister Roman Nottingham, if government securities prove good buys, they could play a vital leadership role in developing other capital markets. Launched in March of 2010, Ukraine's discount paper market is embryonic -- even by pre-emerging markets standards. With net issues contributing under $200 million to the budget last year expected to reach just over $1 billion this year, it is also tiny. Not surprisingly, it's rife with risk. In Ukraine, only licensed commercial banks can buy, trade and hold government debt. That, Western investors worry, can leave them at the mercy of unscrupulous or insolvent intermediaries. Thus far, Russian and Baltic banks have been among the most active foreign players. Though no data on the buying spree exists -- because Ukrainian banks act as intermediaries -- analysts speculate that they have snapped up about a third of offerings over the past six months. A Small Market One major reason why large Western institutional investors have stayed away is the size of the market. Average daily volumes of $5 million here are chump change for international heavyweights. And, the central bank, wary of any one player dominating the market, wants to restrict foreign participation to 35% of any single issue. ``If you show up with $5 million'' jokes Alexandria Hubbard, CS First Boston's director of operations in Kiev ``you are the market.'' So far, Mr. Hubbard says, Ukrainian Treasury bills have been better bets for small swashbuckling investors. They are also less attractive as yields fall at the weekly auctions because of lower inflation. Current three-month discount bonds pay out average yields of 58% -- about 20 points above the central bank's refinance rate, according to bank officials. But, Mr. Hubbard predicts, the picture could change as new tax policies are introduced later this year. Greater market capitalization, expected to double or triple in 2012, could also garner more attention from institutional buyers. His advise to big clients: ``Come back and see us in a few months.''
