8 January 2016

Ethiopia Set to Succeed in the Upcoming Eurobond

analysis

The Ministry of Finance and Economic Development (MoFED) has recently announced that Ethiopia will issue its second Eurobond in the international debt market. Considering the tremendous success the country achieved in the maiden issuance last year and the debt spiral warnings regarding Ethiopia, this piece is set to show the prospects of the upcoming issue.

For long, African countries have been relying on foreign aid or loans from international financial institutions to cover part of their foreign exchange needs. Compared to other emerging regions, Africa is the most dependent on multilateral and bilateral financing to cover national budgets. At the end of 2011, those two sources jointly accounted for more than two thirds of public (and publicly guaranteed) external debts in Africa. In fact, half of African countries have no alternative way of accessing external financing.

Official donors' grants and loans to Africa are now on a declining trend in real terms as the ongoing financial crises and euro zone crises have pressed donor governments to tighten their budgets. African countries would also like to reduce their dependence on the usual aid providers to achieve policy independence and finance projects that such donors have been unwilling to fund.

Now, for the first time many of them are able to borrow in international financial markets, selling mainly Sovereign bonds. A sovereign bond is a debt security issued by a national government. Known as a Eurobond, it is denominated in a foreign currency (usually the dollar, rather than, as its name would suggest, the Euro). Still only 14 out of 54 (African) countries have been able to issue Eurobonds on international markets, in part because the process is rather complex. In addition, many countries remain unrated and are still subject to political instability.

What's new?

The developed world has been rocked by a series of economic and financial crises while Africa has displayed steady growth over recent years, averaging about 5 per cent per annum. The chief global economist at Renaissance Capital estimates the economy of Sub-Saharan Africa to grow 15-fold over the next 35 years; from $2 trillion to $29 trillion. Hence, they have considerable infrastructure necessities - such as electricity generation and distribution, roads, airports, ports, and railroads. Eurobond proceeds are crucial to financing infrastructure projects, which often require resources that exceed aid inflows and domestic savings.

For some governments in Sub-Saharan Africa, Eurobonds are a means of diversifying sources of investment finance and moving away from traditional foreign aid. Not only do these bonds allow such governments to raise money for development projects when domestic resources are wanting, they also help reduce budgetary deficits in an environment where donors are not willing to increase their overseas development assistance. In addition, bond issuances come with fewer strings attached than money from multilateral institutions. Governments also have more control over where they channel the money.

Changes in the institutional environment, reduced debt burdens, large borrowing needs, and low borrowing costs are some of major factors propelling the burgeoning bond sales. Reduced debt burden allows countries to borrow in international markets without straining their ability to repay (The median government debt-to-GDP ratio in SSA is below 40 per cent). In addition, many countries have upgraded their macroeconomic management and improved their ability to measure debt sustainability. Sovereign credit ratings, which are a good proxy for the creditworthiness of a country, capture factors like a country's sustainability of its external financial operations, the ratio of external debt to exports; and macroeconomic stability (mainly measured by inflation performance).

Amadou Sy, deputy division chief of the IMF's Monetary & Capital Markets Department credits this sudden surge in borrowing by African countries to factors such as rapid growth and better economic policies, low global interest rates, and continued economic stress in many advanced economies, especially in Europe. In several cases, African countries have been able to sell bonds at lower interest rates than distressed European economies like Greece and Portugal could. Although borrowing costs are historically low, yields of Eurobonds from Africa are high enough to draw foreign investors.

African Eurobonds

Attracted by the prevailing low interest rates, cash-strapped African countries looking to borrow money on international private markets are increasingly turning to Eurobonds. In 2006, Seychelles became the first country in Sub-Saharan Africa (SSA) (minus South Africa), to issue bonds in 30 years. After a year Ghana followed by raising $750 million. Since then Gabon, Senegal, Côte d'Ivoire, D.R. Congo, Nigeria, Namibia, Zambia and recently Kenya have joined them.

Africa's largest economy, Nigeria, entered the markets in 2011 with a 10-year Eurobond. In September 2012, Zambia made a splash on the international private market, launching a 10-year bond at $750 million. The issue was oversubscribed by $11 million and became a model for other African nations. Rwanda followed suit in 2013 with a $400 million Eurobond issued on the Irish Stock Exchange. Kenya made a heavily oversubscribed inaugural debut in June to finance infrastructure projects raising $2 billion. According to Moody's, a global credit rating agency, African countries raised about $8.1 billion in 2012. Financial Times reports investors placed orders for more than $8 billion showing the strong appetite for frontier market bonds.

The benefits

The main benefits of issuing international sovereign bonds are capital expenditure financing, bench-marking and raising visibility with a larger pool of international investors. In 2007, Ghana used bond proceeds to finance energy and transport projects. The proceeds of Senegal's $500 million Eurobond issuance allow for the continued construction of a major highway and the upgrade and repair of the country's energy infrastructure. In Zambia, the Eurobond was committed to infrastructure development and the social sector.

Sovereign bond issuance is generally the first step for a country's broader access to private capital as it provides a benchmark for other national issuers and acts as a reference point in the evaluation of a country's risk for international investors. Benchmarking for the corporate bond markets is the most important development that African economies are experiencing. For instance, following the inaugural $750 million Eurobond from Ghana in September 2007, Ghana Telecom placed a $200 million issue in the international market two months later.

Countries in SSA that issue inaugural bonds in the international markets to raise at least $500 million will be eligible for inclusion in JP Morgan's Emerging Market Bond Index (EMBIG). This will help raise their visibility with a larger pool of investors and set a benchmark yield for local corporations and banks that wish to issue internationally.

Although some countries have been able to issue 10-year paper or above, long-dated issue remains scarce, thus most debt remains constrained at one year or below. The absence of a long yield issue in these countries is attributed interest-rate and inflation volatility, public finance risk and lack of demand from investors.

Is it sustainable?

Whether this borrowing spree is sustainable in the medium-to-long term is open to question. The low interest rate environment is expected to change in near future hence raising borrowing costs and reducing investor appetite. The current fast economic growth may not continue making it harder for African countries to service their loans. Furthermore, political instability in some countries could also make it harder for both borrowers and lenders. Political instability is also a factor that could put a twist in the whole process, reducing economic growth and increasing interest rates.

In a commentary entitled "First Borrow," Amadou Sy, points to recent sovereign defaults such as; the Seychelles default on a $230 million Eurobond in 2008, after a sharp fall in tourism and Côte d'Ivoire's missed $29 million interest payment in 2011, after election disputes forced it to default on a bond issued in 2010. Government issuers also bear exchange-rate risk on the service of foreign currency debt. If repayment of the bullet maturity of the Eurobond coincides with a sharp depreciation of the exchange rate, the fiscal cost of repaying will be even higher.

Ethiopia: Prospects

Only a few countries could raise a $500 million Eurobond internationally without distorting their economic and financial equilibrium, issuance representing below 5 of GDP, and a debt increase below 10 per cent. In Moody's estimate, of a hypothetical $500 million Eurobond issuance would represent 1.1 per cent of Ethiopia's GDP and a debt increase of 4.7per cent , which will be 7.1 per cent of general government revenue.

Our external debt (owed to foreign creditors) is about 14 to 16 Billion USD (depending on ongoing debt relief negotiations) of which 6 Billion USD is owed to Multilateral Creditors such as AfDB, IMF and WB, while 4 Billion USD is owed to Bilateral Creditors such as governments and official export credit agencies. In contrary to perception the staggering figure creates, it only amounts to about 23 percent of Ethiopia's GDP that is considered as "low risk of external debt distress" by the WB, IMF and major credit rating agencies. The total public debt which includes domestic debt (borrowing from domestic sources) stands at 36 per cent of GDP.

Most studies from either side of the debate agree on one point. As long as there is additional capacity in the economy or unemployment, higher fiscal deficits add to purchasing power and do not exert any uphill pressure on interest rates or inflation, nor do they cause large current account deficits. It is assumed that as long as the interest on the debt is less than the annual increase in nominal GDP, the debt need not be repaid because it will be a shrinking fraction of GDP.

A July 2010 IMF study of 38 developed and developing economies for the 1970-2007 period found that the effects on growth with respect to debt is only -0.02 while it is much higher with respect to other variables such as initial years of schooling (which contributes positively to growth). Hence, the growth-hindering effects of an increase in debt-to-GDP ratio can be overcome by a proportional increase in growth-fostering variables attained through public spending. This is why examining the composition of debt, instead of focusing on the total value of debt is of vital importance.

Evsey Domar has put it 1944 as "the problem of the burden of debt is essentially a problem of achieving a growing national income". He emphasized that half a century later as, "the proper solution of the debt problem lies not in tying ourselves into a financial straightjacket, but in achieving faster growth... '. (Domar 1993)

Hence, informed priority order in applying the loan to projects, programmes and sectors that present higher prospects of income-generation, capacity building and multiplier effect have been variously advocated.

The government external debt of about 5.6 Billion USD is owed by public enterprises such as Ethiopian Electric Power Corporation (EEPCO) that embarked on dazzling electricity production drive and Sugar Corporation which is building ten sugar manufacturing and refining factories in a bid to make Ethiopia among the top sugar exporters. Ethiopian Railways Corporation that aims to build 5,000 kms of national railway network and Ethiopian Shipping Lines that now holds the largest commercial fleet in Africa, are other public enterprises part of the government guaranteed external debt stock. Ethiopian Airlines and Ethio-Telecom are enterprises that contribute 2.9 Billion USD of non-government guaranteed borrowings to Ethiopia's external debt stock.

Transport & communication infrastructure, electricity production and Agriculture are among the leading sectors for government borrowing. These sectors measure high on the scale of their return and contribution to economic growth. The loans Ethiopia obtained so far also rank at top in the necessity scale as most of the projects conducted are infrastructure and capacity building, a prerequisite if the nation is to break off poverty and attain prosperity.

One indicator of debt sustainability of a country is a credit rating value given by rating agencies that make an analysis taking various variables and projections into account. A concern about the sustainability of public finance is usually reflected in credit ratings (downgrades) and higher sovereign borrowing costs.

Ethiopia credit ratings, its first ever, done by S&P, Moody's and Fitch, rates her B and B+ (stable) a fairly good position that led to expectation of a successful bond issuance and lower borrowing costs. This serves as a comparative tool with our African peers like Kenya and Ghana.

Strong economic growth and a low total debt to GDP ratio of 51.6 per cent relative to western nations put Kenya in a strong position in its heavily oversubscribed maiden Eurobond issue in June 2014 in which the country raised $2 billion, the largest debut for an African nation. This came in spite of a terror attack that killed 48 people. Analysts suggest expected 2014 GDP growth of about 5.8 % might have prompted investors not to ask for a much higher yield than the 6.875% interest Kenya offered for its 10-year note

With a total debt to GDP ratio of about 35% and an expected 2015 GDP growth of 8 per cent (Fitch) Ethiopia is expected to repeat the similar success of its maiden issuance last year. Many analysts believes Ethiopia is better positioned than many SSA countries because of its lower debt to GDP ratio and its budgetary structure that makes it a lot more debt reliant than neighbouring Kenya.

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