President of Uzbekistan Shavkat Mirziyoyev is hosting an important regional summit in July 2021. Photo: AFP / Presidency of Uzbekistan / Anadolu Agency

The countries of Central Asia – Afghanistan, Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan and Uzbekistan – need long-term private capital to finance infrastructure. Local governments and international financial institutions cannot cover all requirements, nor should they, especially since there are a significant number of value-for-money projects across the region. 

Moreover, given the high probability of elevated long-term inflation uncertainty in most Central Asian countries, that is, the difficulty of predicting the value of local currencies over a longer period, there are no well-developed local bond markets.

Despite the uncertainty, the finance ministers of the Central Asian countries are not ceasing to look for ways to raise long-term funding.

Repeated international financial crises reveal over and over the need to cultivate domestic bond markets to decrease reliance on foreign-currency financing and minimize exposure to exogenous capital-market volatility. 

As such, the upcoming Central and South Asia: Regional Connectivity, Challenges and Opportunities Summit in Uzbekistan (July 15-16) is an opportunity to make the case once again that Central Asia is worth investing in.

The summit is not only about regional integration but about “financing connectivity” on terms that harmonize the development objectives of these sovereign nations with those of external stakeholders without giving away their sovereignty. 

The summit, focusing on economic, security and cultural issues, is drawing the world’s attention, and the president of Uzbekistan, Shavkat Mirziyoyev, should be congratulated for his leadership.

Central Asia’s leaders, overcoming historical grudges about one thing or another, wish to advance their socio-economic integration. But they also aim to solidify ties with the US, the European Union, Russia, Iran, Turkey, China, India, Pakistan and Azerbaijan, among others.

Everyone knows that without Central Asia, connectivity across Eurasia is largely a meaningless fiction. To say otherwise is to have one’s head in the sand. 

The leaders of Central Asia agree that the development of reliable and affordable infrastructure is a priority. Removing barriers to capital flows and trade will be front and center issues at the summit.

One of the key questions remains: How will these countries, including Afghanistan, tap capital markets to finance long-term infrastructure? Whether through public-private partnerships (PPP) and/or foreign direct investment (FDI), what tools are available to attract financing? 

While countries in the region have made remarkable advances in the regulatory and investment environment, we believe it makes sense to go full throttle on developing the local-currency bond markets, irrespective of howls from some quarters to the contrary. 

Moreover, Central Asia should question those who argue that it will be cheaper to finance long-term infrastructure assets in foreign currencies like the US dollar than in local currency; it won’t be cheaper for Central Asian governments. 

There is a persistent misconception about the assumptions underpinning the risk-reward metrics associated with “fixed income,” that is, debt financing versus equity financing.

To assume automatically that fixed income, that is, “plain vanilla” local-currency bonds that carry significant interest costs to cover for currency-depreciation expectations, is cheaper than equity leads to making wrong choices that turn out to be both costly financially and detrimental policy-wise for the governments and people of the region.

To avoid these problems, the countries of Central Asia should focus on offering in the first instance long-term local-currency inflation-linked bonds not dissimilar to US Treasury Inflation-Protected Securities (TIPS).  

For example, Uzbekistan, Afghanistan and Pakistan have announced plans to construct the Trans-Afghan Railroad from Uzbekistan to the Arabian Sea. Rather than issue US-dollar-denominated fixed coupon instruments, which most likely will be negatively affected by devaluation, financing could be arranged by issuing inflation-indexed long-term bonds (much longer than three years) denominated in three separate currencies, the som, afghani and rupee.

Following such a route would also help develop the local-currency bond market. Only a slice of the instruments could be issued in hard currency, tracking the hard-currency portions of the expected cash flows. Why not? 

Every financing team working on attracting or “crowding in” investors is confronted with the question of how to determine the structure of a capital raise, that is, with what mix and sorts of debt and equity over what period will the asset be financed? 

It is most often argued that the lion’s share of financing should be in the form of fixed coupon debt instruments in both local and foreign currency. How is this decision made?

First the total debt capacity of a project is calculated and then the “foreign-currency capacity” of the borrower – assuming “all else” is pretty much in order, such as the regulatory environment.

This methodology is sub-optimal, that is, leading to greater costs over time, increased fiscal burdens on the government’s balance sheet (the implied foreign-exchange risk taken by the government from borrowing in foreign exchange) and, even, greater dependencies on foreign debt (while not supporting the development of a domestic bond market).

In retrospect, Turkey, which partially followed this course, is one of many countries experiencing budgetary shortfalls and problems in meeting debt obligations. 

Why should Tajikistan, for example, which also seeks long-term financial capital, pay attention to this discussion? What is a “fixed income” instrument really all about?

Or looking at Uzbekistan’s or Kazakhstan’s long-term investment plans to build high-value “connectivity corridors” such as highways or railroads, including the ambitious and sensible Trans-Afghan Railway, successful financing might just depend on structuring unique inflation-indexed fixed-income local-currency bonds with 15-to-20-year maturities.

Investors do not just want the same number of tenge, afghanis, rupees or som back; rather, the investors want their “purchasing power” back (or they will ask for very high interest rates to cover for that exposure, which could be mitigated with the issuance of inflation-indexed bonds).

Why sub-optimal?

Digging a little deeper allows investors to understand why fixed debt instruments are not optimal and helps explain how Central Asian countries might better finance their infrastructure development projects.

Let us assume that it is possible to finance 50% of a highway project with 20-year 15% yielding local-currency bonds; the other 50% is financed with equity. Clearly, the real return to the bondholders is affected by the level of inflation over the coming 20 years. If real inflation turns out to be far higher than the anticipated rate of inflation, the minimum pricing threshold, the investor’s real yield will be far lower at each maturity.

Often overlooked, the return to the equity holder is also affected by the real inflation over the same period. Since the real income generated by the asset is distributed to both the debt and equity holders, whatever real income did not go to the debtholder, the remainder is apportioned to the equity holder. The downside for the bondholder is the upside for the equity holder; this remains true in Central Asia.

The critical point to grasp is that equity holders do not demand at the outset the windfall from inflation nor need an inflation-leveraged real asset, that is, X% plus two times IMF “validated” CPI; the equity holder is prepared to give this leverage away entering the transaction; the equity holder wants a real earning asset that retains its value or purchasing power over time.

To achieve this, the issuer should link the debt instrument to inflation, that is, create an inflation-linked bond. As such, if inflation turns out to be far higher than expected, then both equity and debt holders will not be affected as they otherwise would be if they were holding non-indexed bonds. 

Therefore, Central Asian governments should consider issuing inflation-linked bonds. As a result, bond investors would be able to focus exclusively on the credit risk in the capital structure and accordingly price their bond yields – hurdle rates – far lower than before (that is, there is no need to cover ex ante for the currency exposure).

In turn, equity holders having recourse to additional funding from inflation-indexed bonds will also benefit from lower cost of debt and therefore higher expected returns. This product would be attractive to a larger pool of foreign investors who otherwise would not be interested in Central Asia. 

A word about foreign currencies 

The euro and dollar are the currencies most used in Central Asian foreign-currency debt instruments. The benefit of structuring in these currencies for debt holders is that inflation expectations are relatively more predictable than for local currencies over a longer period.

As a result, foreign-currency debt holders are prepared to charge moderate interest rates (although that assumption may not hold indefinitely given what many experts have deemed as “profligate spending” in certain developed economies).

With foreign-currency debt, the downside risk is in the currency mismatch between the cash flow generated from the earning assets and the liabilities payable in foreign currency. A large devaluation could lead to cash-flow shortages (related to the project) in foreign currency resulting in default, thus scorching the capital markets and the government’s ability to raise capital in a thin market.

Because of this foreign-currency risk, both equity and debt investors want to be compensated in the form of a risk premium, which can be substantially lowered, if not avoided, with local-currency inflation-linked debt instruments.

Note also that a foreign investor is not necessarily worse off by assuming foreign-currency risk. Investors would be entitled to an annual inflation-linked coupon on their money invested plus the return of their money in local purchasing power terms. Converted back into their own foreign currency will, on average, lead to the expected return, that is, the return of the original purchasing power plus yield.

The randomness of the short-term exchange rate, however, will bring in a level of variability such that the longer the term the lower this variability. Note in this respect that a euro investor has this same uncertainty with respect to the return of the purchasing power if the euro are invested in a 20-year fixed coupon euro bond. The variability around this expectation may be even bigger.

And so, as long as inflation in the region remains an issue, infrastructure projects that require long-term capital should be financed, in the first instance, with inflation-linked debt in local currency, not in dollars or euros. And the longer the term, the better these instruments work for savvy foreign investors.

Uzbek, Kazakh or Tajik inflation-linked debt instruments, for example (call them U-TIPS, K-TIPS or T-TIPS), should become priority instruments. Moreover, these instruments would significantly serve to develop the domestic bond market, providing investment opportunities for local institutional investors (that is, local pension funds) and would allow banks to raise long-term funding.

It is highly probable that such debt instruments, all else equal, would be attractive to foreign investors and beneficial for the governments and peoples of Central Asia, helping to underwrite not only the massive long-term costs of the International North-South Transportation Corridor but connectivity westward through the Caucasus into Europe.

And all this could be done without potentially straining the long-term viability of Central Asian governments’ balance sheets. 

Javier M. Piedra

Javier M Piedra is a financial consultant, specialist in international development and former deputy assistant administrator for South and Central Asia at USAID.

Nils De Graaf

Nils De Graaf is an independent asset manager and consultant based in the Netherlands. He is a graduate in econometrics.