Explainer: how do debt crises happen?
Debt crises

This week, G-20—the world’s largest creditors, IMF and World bank have begun discussions about debt restructuring following the increasing frequency of debt default among emerging economies.

These conversations are critical because more than 19 countries worldwide have already begun to default on their loans, while 30 more are at risk of default.

In a Bloomberg and IMF index ranking of 50 emerging countries based on their risk of default, Nigeria is at the 24th position. That’s a better position than Ghana (2nd) and Kenya (6th), but we are worse off than Chile and Cote d’Ivoire.
 

Key takeaways:

  • Global debt has reached the highest it has been in six decades. However, the size of the debt is less of a concern as about 60% of emerging countries are at risk of default. 

  • The debt accumulation speed and default are mostly due to increased access of emerging economies to international capital markets.


Therefore, even if the G20 is discussing debt restructuring specifically for a few countries like Ethiopia and Zambia that have requested it, the conversation will help set the pace for subsequent calls for debt restructuring by indebted countries.

This is not the first time the G20 has gathered to discuss debt restructuring. In 1996, the International Monetary Fund (IMF) and World Bank launched the Heavily Indebted Poor Countries (HIPC) debt relief program. As the name implies, the HIPC was established to bail out emerging countries with severe debt overhang—having way more debt than they could handle. These loans were mostly owed to the IMF, World Bank and G20 countries. Until the early 2000s, most countries in this program owed money to wealthy countries and multilateral organisations.

Today, national debt is a bit more complex, especially in emerging economies. In addition to wealthy countries and multilateral organisations, governments borrow from individuals and organisations through the capital markets (domestic and international). This means that debt relief and restructuring are more complex than they used to be.

And to a large extent, this complexity is one of the reasons for the current increase in debt overhang, which is what I'll explain in this article. First, let's talk about the current landscape of debt default globally.

Today, global debt is the highest it has been in six decades. Although most of the debt is owed by the largest economies—the US and China—emerging economies have increased their debt significantly because of their increased access to international capital markets and their more developed domestic debt markets.

But this increased access has come with an increased cost of debt servicing. Today, the cost of servicing these loans has put about 60% of low-income countries at risk of debt default. A quick primer on different types of loans countries have access to will explain why access to capital markets has been detrimental to emerging economies.

You see, countries typically borrow from two sources. Internally, they could borrow from individuals and organisations through the financial market—like banks and the capital market. External borrowing, however, could be concessional and non-concessional (commercial).

Whether multilateral or bilateral, concessional loans are loans on relatively favourable terms such as low-interest rates, long tenors and moratoriums. These loans are typically cheaper than market loans but may come with conditions the country must abide by to be eligible for the loans. Examples of the requirements are that the country removes energy subsidies and streamlines its ballooning budgets.

These loans may also be multilateral or bilateral. They are multilateral if they come from organisations that are made up of several countries like the International Monetary Fund (IMF) or the World Bank.

On the other hand, bilateral loans come from agreements between two countries (one acting as the borrower and the other as the lender).

But our focus in this article is not on concessional loans but commercial loans—the more expensive loans with little or no strings attached. These loans, which come through bilateral agreements or capital markets, are typically easier to get, as long as the country has a good credit rating, and there's almost no limit to how much you can borrow.

The data shows that some African governments have gone on a borrowing spree.

Between 2000 and 2020, all African countries bar Somalia and Libya borrowed a total of $160 billion from China’s government, banks and companies. Likewise, the combined value of bonds issued by 21 African countries since 2007 is over $155 billion. These debts have now drowned many African countries as they struggle to pay them back.

To make this picture more vivid and relatable, I'll use Ghana as a case study of a country that has had to seek help externally due to its unsustainable debt.
 

Ghana must pay 

This month, Ghanaians are in protest, requesting an explanation for the country's high inflation rate. Ghana's president, Nana Akufo-Addo's reaction was to go to the global big brother, IMF, for a bailout as it nears a debt default. Like many others worldwide, the country is currently going through severe macroeconomic issues like high inflation, high unemployment and much more. 

The common metric for assessing any country's debt sustainability is the debt-to-GDP ratio. According to the World Bank, this should not exceed 77%, otherwise, it is assumed that a country's borrowing activity will negatively affect growth. This is one of the reasons why some might believe that a country like Nigeria (with a debt-to-GDP ratio of 23%) has nothing to worry about. Ghana, unfortunately, does not pass this test. The latest estimates put Ghana's debt-to-GDP ratio at 82%. Regardless, it is worth noting that even the debt-to-GDP ratio is an incomplete metric for understanding a country's debt position. In fact, some of the world's largest economies have a debt-to-GDP ratio of more than 86%. Japan, for example, is sitting pretty at over 260%. Regardless, there is still reason to worry about Ghana's ability to pay back (which is ultimately what matters when you borrow). Earlier in the year, credit rating company Moody's downgraded Ghana's credit rating, warding off investors from its Eurobonds (which then had a high yield), citing that the country was subject to very high credit risk.

This was further supported by an official from JP Morgan who said, "In our view, [Ghanaian] authorities' fiscal consolidation plans—now including a reduction of up to 20% of projected 2022 expenditures—are insufficient to address Ghana's primary fiscal issue of high borrowing costs."

As we explained extensively in this article, a country is perceived to have a credit risk when creditors suspect that the country is insolvent and would struggle to pay back the loans. A country struggles to pay back its loans when it takes on too much at once and earns much less than it can pay back.

The first sign is that Ghana's debt stock has been increasing rapidly over the years. Ghana's debt has tripled in the last ten years, from $15 billion to $59 billion in 2021.

 


But the issue isn't just about Ghana's rising debt but its (in)ability to pay back these loans. With domestic loans—borrowing from local banks and the central bank—the government can request that the central bank print more money to repay the loans, but foreign debt is more complex.

Foreign debt requires foreign currency for repayment, which could come from investments or loans. The thing with foreign debt is that the country has very little control over the rates at which they get the loans—especially when the loans are obtained through fixed income instruments in international capital markets.

Loans from the foreign capital markets have their benefits: first,  they don't come with conditionalities like multilateral debt. Although their rates are subject to market forces, when the countries perform well in the foreign capital markets, their credit ratings—which determine the performance of the loans, influence investment inflows into the country.

Given this context, let's look at the composition of Ghana's debt over the years to understand how it contributed to Ghana's near-default and its need for a bailout from the IMF. First, we look at how Ghana's debt has increased over time.
 

 

This is not the first time Ghana requested a bailout from the IMF. 

In 2002, Ghana's debt—particularly to the World Bank and other governments was 120% of the country's GDP. Therefore, it entered into the HIPC debt relief initiative for two years. During this time, Ghana was expected to implement poverty reduction strategies to make the future debt more sustainable.

After this, in 2005, the World Bank and IMF wiped out over $4 billion of Ghana's external debt, reducing its debt by almost 70%.

This is yet another advantage concessional loans have over commercial loans, especially for countries battling corruption; the multilateral organisations don't just give out loans but ensure that the countries implement policies that help them maintain sustainable loans over time.

Do these policies always work for these countries? No, they don't because many of them are politically unpopular and can sometimes lack the nuance suitable for that country at the time of implementation.

For instance, Ghana’s Structural Adjustment Program is associated with times of hardship and political unrest. Also, there are reports that Ghana exited the IMF’s Poverty Reduction and Growth Facility because it was restrictive and sought funding from the capital market instead. However, we can say that the IMF’s bailout was instrumental in Ghana’s stable debt stock from 2005 to 2011. So, why is Ghana back to beg the IMF for yet another bailout? Let's check the data to find out.
 


After the bailout in 2005, Ghana’s external debt reduced and was pretty stable. However, in 2007, Ghana issued its Eurobond and has not turned back from borrowing from international capital markets since then. At the time, its debt levels were still quite manageable, so even though the country issued a $750 million Eurobond, it made up 21% of its total debt stock—most of its loans still came from multilateral sources.
 


This changed in 2013 when Ghana's economy witnessed a decline in its economic growth—triggered by the mining and agriculture sectors, coupled with declined consumer demand. The Ghanaian government turned to the international capital market. That year, its Eurobond issue increased significantly and went on from then on. Now that I've painted the picture, it's time to talk about its implication on the Ghanaian economy and why it has led the country to a near debt default.



Despite how attractive foreign debt is, a country's ability to service its loans is dependent on its ability to earn foreign exchange to meet its credit obligations when due. The risk, however, is this debt could become more expensive to pay back when the country's local currency is devalued. An excellent example is when the Ghanaian cedi lost 40% of its value, Ghana's first Eurobond of $750 million became valued at $3 billion.

 

 

From the chart, it appears that Ghana’s domestic debt increased just as fast as the foreign debt. However, as I mentioned earlier, domestic debt is usually much easier to pay back because the country earns in that currency. Although the country's foreign debt has increased by 1.3x since 2013 in dollar terms, the Ghanaian government would have to pay 5x more to repay the loan.

This currency risk could also happen to a loan owed to a multilateral organisation. However, unlike the capital market, the multilateral organisation might be open to a debt restructuring, given that the default is caused by currency devaluation.

In addition to the exchange rate, another risk of foreign capital market loans is that as a country's debts become more expensive and its ability to pay dwindles, its ratings could be reviewed downwards. With a low rating, the interest rates on the country's instruments are higher, or the country is completely shut out of the capital market.

This was Ghana's fate. When Ghana's rating was reviewed downward on account of being very risky, the yield on its 10-year Eurobond increased to 22%, the highest it had ever been since 2020. Before 2020, this Eurobond yield was less than 10%. This rating then dashed Ghana's hopes of issuing another Eurobond in 2022—the country could no longer get money from the capital market.

Here's the thing, when countries go through economic downturns as Ghana has due to Covid and growth decline in the economy, it looks to external sources for financial support. Unlike multilateral sources willing to work with the country on its path out of poverty, the capital market instead punishes the country for its inability to pay back as at when due.

The implications of such a rating go beyond the inability to raise money in the capital market to how foreign investors perceive the country and their reaction to its investments. 

These are the issues that led to Ghana's debt situation.

The bailout from the IMF, therefore, means the organisation will stand as a guarantor on behalf of the country to prove to creditors that the country is on the path to recovery, so they can be given loans again from the capital market. This is not precisely the case, but it's what happens in the market.
 

Nigeria's debt composition

We've used this same logic to review Nigeria's fiscal position and sounded the alarm not once, not twice, not even thrice but four times in the last year about how Nigeria needs to pull the brakes on its borrowing. Even though we refused to stop, the international capital markets have stopped us. Earlier in the year, the Ministry of Finance had to recall two Eurobond issues given the high yields on both in the market. This signals that Nigeria, like many other African countries, will struggle to raise money externally and is headed towards debt distress, but don't take my word for it. Let's look at the data.

Nigeria's debt has risen from $6 billion to $35 billion in the last ten years. But that's not the story for today. Our message today is that debt sustainability is not only about how much the debt has risen but the debt composition.
 


Let's look at what Nigeria's debt composition is like. In 2015, external debt made up less than 20% of our total debt stock, but by 2020, it was 38% of the entire debt stock, and today it's about 40%. In absolute terms, external debt has increased from $10 billion in 2015 to $39 billion today (tripled). However, in naira terms, the debt stock has risen by seven times its 2015 value due to the currency devaluation.

Our debt servicing reflects the increased external debt stock and the currency devaluation. For instance, the commercial debt servicing in dollars increased from $116 million in Q4 2018 to $763 million in Q1 2021—mainly because our 2021 Eurobond of $500 million was mature. Taking that out of the equation, the interest payments increased by $147 million in about two years. Meanwhile, the naira value of our debt service doubled, driven by even more borrowing and the expensive interest charged on the loans taken. In 2020 and 2021, debt servicing was over 90% of the federal government's revenue, putting Nigeria firmly in a precarious debt situation.

Nigeria has yet to default on any loans, and our foreign reserves, although lower than usual, is not entirely depleted. But if the market is any indication of Nigeria's credit position, there's reason to worry. Earlier in the year, the Ministry of Finance had to recall Eurobond issues because the terms of these loans were quite bad (to say the least).

History is another valuable teacher when thinking about debt in Nigeria. In 2004, Nigeria was in severe debt distress and had to choose between developing the country and paying back loans. Again, Nigeria's debt was severe because 85% of its loans were commercial—owed to the Paris club.

These countries are just as strict with their funding as the capital market is, they don't care much for the reforms a government puts in place to improve its economy, but they are more concerned about the possibility of returns from the loans. However, the chance of a debt pardon when a country owes the capital market is slim because the money owed in the capital markets belongs to several investors.

In line with the default risk, JP Morgan downgraded Nigerian bonds from its Emerging Markets Sovereign index earlier in the year due to perceived forex liquidity, among others. This is a reaction from the capital market that Nigerian stocks are becoming riskier to hold.

This again points to the fact that when thinking of the sustainability of a country's debt, it's not enough to think about how much the debt has grown or how much it is compared to GDP (because the people generating the GDP are not directly responsible for paying back the loan).

Globally, it's getting harder to borrow because of the contractionary monetary stance taken by central banks worldwide. Add that to the rising commodity prices and inflation globally, and you have a bouquet of macroeconomic issues strong enough to upend any economy that's too fragile and vulnerable.

Many countries are in this position, and Nigeria is no exception. All we have to do is tidy our fiscal situation and unlock income internally while taking fiscal measures to improve our macroeconomic situation. I must confess, though, that’s easier said (or written) than done. With debt restructuring conversations happening among the largest creditors, there seems to be a solution to the debt overhang problem across emerging economies.

External borrowing looks highly unlikely now. If anything, that's a blessing in disguise because the more we dig into the capital market quicksand, the harder it is to emerge when the creditors come knocking for their money.

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Gbemisola Alonge

Gbemisola Alonge

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