Decades have passed since the international capital market became an important intermediary in mobilising trillions of tradable currencies across the globe from numerous investing and lending institutions, and channeling those funds to sovereigns and private sector institutions. Having passed the rigorous assessment of credit rating agencies with their “black box” methodologies, Ethiopia has entered an important era to offer the international investment community with investment and lending opportunities from being a country that has been the recipient of food handout for decades.
The Ethiopian government has performed admirably in creating alternative avenues of accessing global capital beyond the usual providers of development finance. Beyond economics, entrance into international capital market may have far reaching positive implications for the country’s regional politics.
Bonds are issued to obtain long-term financing by governments and their agencies, and by private sector corporations. Bonds issued by governments are known as sovereign bonds, while those issued by the private sector are called corporate bonds.
Bonds come in several different varieties. The bond recently issued by the Ethiopian government is called a coupon bond. This type of bond pays a fixed income stream called coupon payments to bondholders at regular intervals over the life of the bond, as well as the repayment of the face value (nominal amount) of the bond at maturity.
The recurring coupon payments are akin to an annuity and are calculated by multiplying the nominal amount with the coupon rate. Therefore, the investor invests a lump sum upfront and in return receives a recurring series of coupon payments and the nominal amount at maturity. These fixed income bonds are issued at a discount or premium depending on the level of the coupon rate relative to ruling market interest rates (yield curve) for bonds with similar durations and credit ratings at the time of issue.
The market value of a bond is the sum of the present value (discounted value) of the future coupon cash flow stream, and the present value of the lump sum at maturity. The rate used to discount the future cashflows of the bond to its present value is called the yield-to-maturity (YTM).
The YTM is derived from the ruling yield curve and is adjusted with a credit risk premium. If the YTM is higher than the coupon rate, the bond is issued at a discount. But if the YTM is lower than the coupon rate, then, the bond is issued at a premium.
The YTM, therefore, represents the yield that an investor expects to earn over the life of the bond if the investor holds the bond to maturity. Once issued, the market value (price) of a bond changes constantly in tandem with changes in the yield curve and changes in credit expectations. The value of the bond therefore changes continuously because, although the future cash flow stream is fixed, the discount rate (or YTM) changes continuously due to changes in the yield curve and changes in credit expectations.
The Ethiopian government bond was issued at par with a coupon rate of 6.625pc, implying that the coupon rate was equal to the yield-to-maturity at the time of issue. Future cash flows that the Ethiopian government will pay on the bond are determined by the coupon rate, which is fixed over the lifetime of the bond, as well as the fixed face value repayment at maturity.
This means that while the cash flows that the Ethiopian government will pay over the life of the bond are fixed, the market value of the bond will change due to changes in the YTM. Should market interest rates decrease, then, the market value of the bond will increase and investors will realize a profit if they chose to liquidate their holdings.
Conversely, investors will realize a loss if market interest rates rise and they chose to liquidate their bond holding. Alternatively, investors who hold the bond to maturity will earn an effective yield of 6.625pc over the lifetime of the bond.
Hence, the best measure for the return on investment in bonds is the YTM, which equals the coupon rate plus interest on the coupon receipts, plus the capital appreciation (or capital depreciation) of the difference between the purchase price and maturity value of the bond. Investors who do not hold the bonds to the maturity earn an Effective Period Yield (EPY), which is calculated in the same way as the YTM.
There are many arguments that are forwarded to governments of developing countries to borrow from the international market. One is that governments should get a feel of the market by getting independent assessment of their economic management. Yet another argument that governments borrowing in the international market help set a benchmark rate against which international lenders could price the commercial borrowings of their local private sector.
Whatever the case, governments borrow either to finance their revenue shortfalls or to bridge liquidity shortages constraining their economic reforms. Whichever angle one looks at it, recourse to foreign currency denominated sovereign debt by countries, such as Ethiopia, needs to be approached with due care. Considerations ought to be made about the purpose for which the borrowed funds would be used, the country’s fiscal situation and its debt profile, the macro-economic implications of such borrowing, and planned policy objectives that will have a trickle down effect in the economy.
The economic policies implemented by the current Ethiopian government have led to impressive economic growth rates. To maintain this growth rate and achieve the government set objectives in each major sector of the economy, it requires massive financial resources that are beyond local savings as well as financial resources that the government can mobilise by issuing bonds through international capital markets. Mobilising these resources the country needs for its development may require a paradigm shift to the current resources mobilization strategy.
In addition to the traditional long-term saving institutions, the emergence over the last two decades of prominent sovereign wealth funds that manage over seven trillion dollars and the ease of crossborder capital flows, have made the international capital market awash with liquidity. Conversely, the slackness of the economic activity in industrial countries, and the associated reduced demand for funds, may be a strong push factor for developing country governments to access global capital markets.
However, economic literature that documented the history of the capital markets over the last 200 years show that sovereign default episodes have occurred sporadically, and the defaulting countries were severely penalised. Default events tend to occur in clusters and usually follow lending booms.
Sovereign defaults occurred in Latin America, Africa and Asia and Europe. Latin America is the region with the highest number of default episodes followed by Africa in a distant second. The first cluster of defaults occurred between 1824 and 1840, followed by a lending boom to Latin American countries that gained independence from colonial rule more than 100 years before many African countries.
Of the 19 default episodes recorded during the period, 14 involved Latin American countries and five involved European. Limited defaults occurred between 1841 and 1860, but that period was characterised by lending booms to developing countries that were responsible for 58 default episodes that occurred from 1861 to the early 1920’s. During this period, 41 default episodes took place in Latin America and eight in Africa.
The next wave of defaults occurred during the Great Depression and the Second World War (WWII). From 1921 to 1940, approximately 39 sovereign defaults occurred. More than half of the episodes happened in Latin America and a third in Europe. By the end of WWII, most developing countries had lost access to international capital markets and only six default episodes were recorded between 1941 and 1970.
From 1824 to the 1970s, sovereigns used to borrow from public bond markets where small investors joined big saving institutions (mainly pension funds and insurance companies) as lenders. Decades of sovereign defaults drove the small investors out. During the 1970s and 1980s, sovereigns mostly borrowed from big banks by means of syndicated bank loans made possible after the oil shock of 1973 when the excess financial reserves of oil producing countries were recycled to the developing countries.
Many developing Latin American and African countries defaulted on the syndicated loans extended by the big banks. Subsequently, the international community spent several years painfully renegotiating and restructuring the sovereign borrowings.
The average re-negotiation and restructuring process lasted over nine years. Credit to developing countries (including those who did not have experience in foreign borrowing) dried up in the aftermath of the syndicated bank loan defaults.
Having burnt their fingers, the big international banks exited sovereign lending in the late 1980s and 1990s. International lending to developing countries only resumed after the restructuring process was complete. The defaulted bank loans were restructured by issuing new, partly collateralised bonds called Brady Bonds, named after US Treasury Secretary Nicholas Brady, who was the main architect of the restructuring process.
The Brady Plan played a valuable role in creating a bond market for emerging market countries. In addition, the low interest rates in the United States, as well as the large and growing reserves of East Asia and oil producing countries over the last two decades, contributed to another era of lending booms particularly to emerging markets. The defaults that followed this lending boom are recent.
Capital markets observed approximately 40 defaults between 1991 and 2004. Of the 40 defaults, 14 were on bonds and 26 on syndicated bank loans.
Most of the syndicated bank loan defaults were African countries that had not previously used sovereign bonds to access global funding with the remaining bond defaults occurring in Latin America. The largest emerging market default transpired during 2001 in Argentina when defaults happened on debt of 81 billion dollars, involving 152 varieties of paper denominated in six currencies and governed by eight jurisdictions.
The issue in question here is why do countries default on their borrowing obligations? What are the costs of default when it happens? What strategies can a country employ to minimize the likelihood of default?
Similar to companies in the private sector, countries default when they are unable to meet their contractual debt obligations agreed at the time of issuing the bond. Default manifests mainly in the form of missed scheduled repayments.
Sovereign defaults do not occur by accident and they are usually widely anticipated by key market players, including speculators. Sovereign defaults usually occur when the domestic economy underperforms significantly relative to expectations.
Fiscal deficits, large trade imbalances, and imprudent foreign currency denominated borrowings are considered to be the key underlying causes of sovereign defaults. Emerging markets with open economic policies are especially vulnerable to attacks by speculators when their economies perform well below expectations.
Countries are also likely to default if their economy is highly susceptible to negative global market conditions which directly impact key products that they offer to the world market. Political instability and crises also increase the likelihood of default.
Default can happen to any country due to factors and circumstances beyond its control. Economic literature suggest that the “default point” for a sovereign should be at the stage where the costs of servicing debt in its full contractual terms exceed the expected costs that will be incurred from seeking a restructuring of terms, when these costs are comprehensively measured.
From the recent Latin American sovereign debt default, one can learn that politicians and bureaucrats are willing to go to great lengths to postpone what appears to be inevitable default. Although the maximum effort should be made to avoid default, delaying it indefinitely may lead to even more adverse economic consequences.
Creditors’ rights to sovereign debt and commercial enterprises differ significantly. In the case of sovereign debt, creditors’ rights are not as strong as is the case with corporate debt. The commercial laws of most countries allow creditors to lay claim to the company’s assets if the company goes insolvent, even if the company’s assets are not enough to cover the total debts of the company. In case of sovereign debt, the legal recourse available to creditors has limited applicability because many assets are immune from legal action and it is usually difficult to enforce favorable court judgment against sovereign assets. However, unless impacted by conditions discussed above, sovereigns usually honor their countries’ debt obligations.
Although there are no conclusive empirical evidences that show the effect of foreign currency denominated sovereign debt default episodes alone on gross domestic product (GDP) growth, there are some studies that show the effect of domestic bond defaults (which tend to happen during deep recession) on GDP growth. In the case of domestic default, GDP is eight percent lower than the GDP four years before the default. However, the studies show that GDP starts recovering in the year after the default and the GDP takes three years to reach the level four years before the default.
Outside of direct GDP growth impact, there are studies that highlight the reputational and international trade exclusions costs of default. In addition to these, there are costs to the domestic economy through the financial system and political costs to the authorities as a consequence of sovereign default.
There are earlier studies that argue that payments to international debts are honored because of threat of permanent exclusion from future borrowing. Such studies were later criticised on the fact exclusion from the capital market was not permanent. In actual fact, countries that had defaulted in 1980 were able to attract large capital flows in the 1990s and countries that defaulted in the 1990’s able to attract capital flows as soon as the restructuring was completed.
From the history of defaulting countries, we can learn that the international capital market does not have a discrimination mechanism in actual lending between defaulters and non-defaulters. However, defaulting will significantly affect the countries’ reputations, substantially increasing the costs of accessing the international market due to lower credit ratings and interest rate spreads that reflect the increased sovereign risk premium. In contrast, the traditional assumptions often made by theoretical finance literature on trade embargos on defaulting countries do not carry much weight due to the current structure of capital markets where bondholders are increasingly anonymous.
Although London and New York are the most significant bond markets, investors can be from any country. Hence, embargos or seizure of sovereign assets is not plausible in case of default. However, governments who default on payments to local financial institutions who are potentially significant holders of locally sold government bonds may ignite a domestic bank crisis that will have serious negative consequenceson the country’s economy.
The substantial cost of sovereign default that is supported with empirical evidence collected so far emphasizes the political cost to the authorities. As with currency crises in regimes with free floating exchange rates, the political consequences of debt crises are disastrous on incumbent governments and finance ministers.
Hence, countries that access capital markets with foreign currency denominated debt should have a strategy to deal with potential defaults. The sovereign’s strategy to handle the cost of default must start during the contracting stage of bond sales.
The sovereign bond contract agreements should be based on Terms and Conditions of Collective Action Clauses of the International Capital Market Association that is accepted by most countries laws, rather than by specific country laws, such as the US, which allow unanimous approval from each individual bondholder for any negotiation on the bonds. This is because, unlike the syndicated bank loan and traditional public bond market investors, where renegotiation and restructuring was possible for sovereign defaults due to small number of participants, the sovereign default in the globalized capital market presents a problem not encountered in 1980s and earlier decades.
Today, unless the contract is carefully drafted as described above, thousands of bondholders, many holding small stakes, have to be present at the negotiating table, leading to an enormous coordination problem. It is difficult to contact some bondholders let alone negotiate on the terms of the bond.
Other strategies are often recommended as best practices after the Mexican financial crisis of 1994-95, the Asian financial crisis of 1997-98, the Russian crisis of August 1998, and the Argentinean crisis of 2001 which all happened in the new globalised financial system, include the development of risk-based approaches to the management of public debt and creating a vibrant local bond market.
Although emerging countries benefited over the last decade by adopting risk-based public debt management systems and creating a vibrant local bond markets, implementing these strategies require considerable work in countries like Ethiopia. For instance, the vibrant bond market requires strengthening existing long-term saving institutions (insurance companies and pension funds) and creating other new institutions for nationwide savings mobilisation and establishing legal and regulatory frameworks for the effective use of supporting institutions such as rating agencies. On the other hand, an effective risk-based public-debt management system requires significant capacity building of public finance professionals in best practices and tools. Minimizing interference from politicians in implementing consistent macro-economic policies has also significant contributions for effective public-debt management system.
Public debt management is always an important function in any government. Emerging market governments need extra precautions and pro-active macroeconomic management if they have significant portion of foreign currency denominated debts in their public debt-portfolio. This is because speculative attacks are highly likely if there is an apparent macroeconomic imbalance. Hence, to minimize risk in relation of default to foreign currency denominated debt, the ultimate goal for any emerging market government need to be to issue local currency denominated bonds to both international and local capital markets.
In a way, although the routine management of trade imbalances and foreign debt are still important functions of Ethiopia’s Ministry of Finance & Economic Development (MoFED), the country’s long-term public debt management goal should be to move away from what economists call the “original sin” – borrowing foreign currency denominated debt in the global market.
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