- First Published on February 15, 2019 on LinkedIn
- Republished with permission from Author
About Author
Gregory Smith is Director, Fixed Income Strategist, Emerging Markets, at Renaissance Capital
In 2019 the cost of servicing government’s external debt is set to increase by 90%. $1,408 million will leave the country to repay debts compared to $742 million in 2018. This will put large pressure on the government’s finances.
The leadership faces a tough choice, if it continues to cut ribbons (on new infrastructure projects) it runs the risk of an economic crisis before the 2021 elections (and during the next term if they won). Alternatively, and to reduce debt risks, the largesse would have to stop.
To reduce debt risks, action would be needed, requiring an immediate shift from the current complacency to a more urgent stance.
Capital flows must be attracted to increase investment
The Zambian economy grew at a rapid pace of 7% between 2004 and 2014. This size of the economy doubled in just a decade. The slowdown of 2015 has passed but growth of the economy has lumbered around 4% per year since, reasonable by some standards, but not enough for economic transformation.
Investment is needed to further develop infrastructure, raise the quality of schooling and health care, and equip the rapidly growing urban areas with the sewers, safe water supply, and public transport they need. However, the biggest challenge to further increasing investment remains attracting capital flows. Domestic savings are insufficient to finance the investment needs, as Zambia is not yet rich, and when Zambians do accrue wealth, they tend to invest in furthering their education, or buying plots and laying bricks (they do not tend to leave savings in the bank). This means financial capital is needed from abroad.
The best sort of inflow to attract is foreign direct investment (more permanent capital). Less good is commercial debt (with maturities of 5- to 15-years), and least good is short-term debt (called hot money as flows can reverse at the first sign of market panic).
Zambia has borrowed aggressively since 2012
Since 2012 the government has:
- Borrowed regularly from the Chinese and traditional sources for clearly defined projects.
- Accessed discretionary financing via $3 billion in eurobond borrowing on commercial terms (Zambia issued in 2012, 2014 and 2015).
- Taken ‘bridging loans’ from the Bank of Zambia (especially in 2013, between the first two eurobond issues).
- Signed syndicated loans with commercial banks.
- Converted fuel payment arrears into loans.
- Scaled-up the issuance of government securities (Kwacha treasury bills and bonds) in 2016 and 2017.
Over this period, the debt-to-GDP ratio (which compares government debt to a year’s output from the entire economy) increased from 25.4% in 2012 to 70.9% in 2018 (IMF data).
External public debt increased from $8.74 billion in January 2018, to $9.51 billion in October 2018 (excluding government guarantees, estimated at $1.2 billion).
It is becoming harder to borrow
The external sources of debt were saturated by the end of 2017 and the domestic sources of debt by mid-2018. The second half of 2018 was the first period the government did not have access to flows of borrowed funds. It has since faced a harder budget constraint. This budget constraint looks set to tighten further from 2019 as government must now repay more of what it has borrowed.
Not paying the debts, i.e. defaulting, is not a sensible option for government. There is a lack of agreement about the economic consequences of a default, but defaults have been very painful for many countries, especially disorderly or lengthy defaults. Zambia would likely experience a sharp decline in exactly the investment it is trying to promote, and the economy would emerge relatively smaller. Future borrowing would be more expensive, and a period of outright capital market exclusion could not be ruled out.
Market access, such as new issuing eurobonds, is already problematic at current debt levels, especially without an IMF program. This harder budget constraint will certainly apply more pressure on the build-up to the 2021 elections.
Debt repayment issues are not on the horizon, they impact in 2019
Zambia was downgraded by all three credit rating agencies in 2018 as they saw increasing debt risks. The price paid by investors for Zambia’s eurobonds plummeted in 2018 as investors panicked about weak markets and their concerns about Zambia’s debt risks increased.
The first eurobond, issued in 2012, does not mature until 2022, but before then, the government will need to find the resources to repay many other loans.
The cost of servicing the external debt (i.e. what government owes to foreigners in foreign currency) is projected (by the finance minister) to increase by 90% to $1,408 million in 2019, from $742 million last year. Debt service costs include both interest payments, and the repayment of debt to lenders like the World Bank and African Development Bank, to China, and to international commercial banks. The external debt interest payments are set to increase from $246 million in 2018 to $582 million in 2019. Of this amount $237 million (41%) is needed to pay the coupon (interest cost) of the three eurobonds.
Many Chinese loans have grace periods of 3 to 5 years before they needed to be repaid. Grace periods on some of the larger loans end in 2019 and the Chinese will want Zambia to start paying them back for extending Kariba dam’s north Bank (hydro-electricity) and the $5 million per km Mongu-Kalabo road that spans the Zambezi river.
In 2018 approximately 27% of all the revenue government collected was used to pay interest on external debt and domestic debt. A further 45% is needed to pay the government wage bill, leaving just under a third of revenue for all the development and economic transformational expenditure needs.
What makes matters worse is that the government has run down its foreign exchange reserves since 2015 to just $1.6 billion. Other countries build up foreign exchange reserves so that they can be deployed in case of a negative shock (such as a fall in the copper prices). When investors see healthy reserves, they worry less, and a country can often borrow at a cheaper rate. Zambia’s low level of reserves are viewed by investors as a clear vulnerability.
The government guarantees are linked to state enterprises, such as ZESCO (the national electricity utility). ZESCO is reported to have its own challenges, including inefficiency, and delays in paying suppliers. If ZESCO were unable to pay its debt they would become the obligation of its owner, the government.
Measures in the 2019 budget should raise additional foreign currency revenue from mining companies (including via a higher copper royalty rate, and a levy on gold and gem exports). This will help in 2019, but if government squeezes the sector too hard, and companies are not making profit, there is unlikely to be new investment in future.
A sinking fund has frequently been cited as a counterbalance to repayment risks in Zambia. A sinking fund is working in Namibia where the government reports that it has accumulated $408 million to help repay its eurobonds. However, Zambia allocated just $10.5 million in 2018 and there does not look to be a budget allocation in 2019. An empty sinking fund will not help.
What could be done to reduce debt risks?
The leadership faces a tough choice, if it continues to cut ribbons (on new infrastructure projects) it runs the risk of an economic crisis before the 2021 elections (and during the next term if they won). Alternatively, and to reduce debt risks, the largesse would have to stop.
To reduce debt risks, action would be needed, requiring an immediate shift from the current complacency to a more urgent stance.
- Reduce the pipeline debt. The finance minister said government would postpone and cancel projects in 2018, but there is yet to be any sign of action. This might be because there is little scope for cancelling projects when they are half built. However, the government could make the tough decision to delay or cancel some pipeline projects where construction has not started. For example, they could cancel or delay the Chipata-Serenje railway (estimated cost $2.3 billion), the Kafubu dam ($450 million) and rethink the proposed $1.2 billion highway to the Copperbelt (the cost could be reduced to say $200 million by just working on expanding width in the busiest sections).
It is not about stopping infrastructure development forever, but about pacing it more sustainably. An infrastructure pause might also be helpful as it would give government a chance to build a system that adequately designs, appraises and implements the projects, and in doing so limit costly mistakes and reduce the avenues for corruption.
- Reorient government expenditure to the revenue collected. Government needs to deliver on its pledge to reduce thefiscal deficit to 4-5% GDP.
- Sign a program with the IMF.Since 2014 the government has been talking about this. There is reluctance because past programs, under the guise of structural adjustment, were negative for Zambia’s economy. However, many other African eurobond issuers have a program. And the IMF packages are now better designed, thinking through the financial and political costs of reform better than they did in the 1980s and 1990s. A program would help top-up foreign exchange reserves and restore investors’ faith in the planned reforms. This would help in attracting the better types of capital flows (foreign direct investment) as well as reducing the debt risks.
- Ask for betterterms from the Chinese. There is scope for Zambia to negotiate longer maturities and the extension of grace periods on ongoing Chinese projects. Ethiopia and Botswana managed. Here Zambia must take the initiative, by not just asking for support, but instead by being precise about the changes on specific loans they want. Chinese lending is from different sources within China and they are not easy to coordinate.
Ideas 1 to 4 are the more straight-forward. The following two ideas are more maverick and would need to be carefully thought through by government.
- Sell some assets. Several state-owned companies have been tabled by government for privatisation, including the fuel pipeline to Dar es Salaam and refinery. Their sale could raise much needed dollars. The government also owns shares in some copper mines via ZCCM Investment Holdings that could be considered if the need for foreign exchange intensifies.
- Get a bail-out from affluent others. Lebanon, Pakistan and Bahrain are each reported in the media to be getting support from the Gulf to ease their debt pressures. Mongolia drew down on a bilateral currency swap facility (for $2.18 billion) with the People’s Bank of China that provided external buffers in 2016 and 2017. Zambia could seek some financial backing from a more affluent friend (but such deals might not come without obligation).