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Monday, 18 August 2014

Eurobonds : weighing the risks against gains

Editor’s note: A recent article from Albert Halwampa (ZIPAR) on the costs and benefits of external borrowing through Eurobonds. It argues for a comprehensive legal and institutional framework to address the risks associated with this form of debt instrument. 
There has been recent media speculation about the government issuing another Eurobond – the third in two years. Earlier this month, the Ministry of Agriculture and Livestock talked about the possibility of floating a bond to plug the US$400 million financing gap in agriculture. This has resulted in apprehension in some quarters of the economy regarding the risks associated with this seemingly allure of Eurobonds. I therefore attempt to weigh some of these risks.

Zambia successfully issued its first US$750 million Eurobond in 2012. It was oversubscribed with an interest rate of just over five percent. In 2014 another Eurobond, amounting to US$1 billion was issued with a higher interest rate of over 8.5 percent, and a lower level of oversubscription - just US$4.25 billion.

While the former shows a high level of investor confidence at relatively lower interest rates, the latter shows some degree of waning investor confidence. A sum of US$128 million will be paid in annual interest to service these debts up until 2022 when the first bond will be paid back. Against this backdrop any third Eurobond requires careful consideration.

There are clear benefits to Eurobonds. Zambia has a huge infrastructure deficit in various sectors of the economy that requires substantial amounts of funds.

Now that Zambia is a lower middle-income country, it has less access to cheaper loans from the bilateral and multilateral lenders making commercial borrowing more necessary. It makes good economic sense for the country to borrow to fill the public spending gap to accelerate economic growth, poverty reduction and employment creation opportunities.

There is another argument for borrowing more now. During the recent financial crisis, most of the countries in the developed world embarked on stimulus plans to stabilise their economies. The measures resulted in interest rates falling to almost zero. Bond investors had to look to more attractive interest rates that prevailed in the emerging markets.

Borrowing money from international financial markets is a strategy which has significant potential, but also one with enormous downside risks. Zambia’s own history and more recent experiences in countries like Argentina, which in 2001 defaulted on US$81 billion worth of bonds, demonstrate the scale of these risks.

There are three particular risks for Zambia, each of which needs an adequate response before taking on more substantial debt.

First, there is the risk that increased capital investment projects financed by Eurobonds may be poorly selected or executed and fail to generate more economic growth and therefore increased government revenue. Increased public capital investment, for example in the transport and energy sectors, may also lead to pressure to increase recurrent spending such as maintenance, which may be hard to contain. Zambia, therefore, needs to invest the proceeds in the right type of high-return projects capable of generating enough revenue to service the debt.

Secondly, there is always market uncertainty in terms of exchange rate and interest rate risks. And the country may be forced to borrow at higher interest rates to services the debts. Bonds may have to be repaid at a time of higher interest rates, or when the kwacha may be weaker making debt servicing expensive. To mitigate against these risks, Zambia should emulate countries such as Gabon and Ghana which have put in place a sinking fund managed by their central banks.

Thirdly, Zambia depends on copper exports for its foreign exchange earnings. This exposes the country to the volatility in international copper prices. In order to adequately assess the opportunities and challenges of borrowing from the international capital market, the Zambia Institute for Policy Analysis and Research (ZIPAR) is conducting a study on Zambia’s entry onto the Eurobonds market. This study examines the experience of other countries such as Argentina, Ghana and South Africa in order to help ensure a more effective debt management system for Zambia.

In order to respond to the above risks we need a comprehensive legal and institutional framework. Arising from such a framework is a sound, forward-looking and comprehensive debt-management structure with well-trained and remunerated debt managers.

One important point is that the Ministry of Finance will require building expertise in debt and risk analysis. In the finance sector this is referred to as the “middle office”. It undertakes portfolio analysis, develops a risk management strategy and develops borrowing scenarios and compares emerging debt indicators with agreed benchmarks. As Joseph Stiglitz, a Nobel laureate economics professor, predicted: “If analysis of risks involved in borrowing from the international markets is not rigorously undertaken, the debt crisis will again return to sub-Saharan countries.”


Albert Halwampa is a Researcher at the Zambia Institute of Policy Analysis and Research (ZIPAR).

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