CÉLESTIN MONGA
To develop a proper understanding of the risks facing indebted African countries, international financial institutions must overhaul their own methods for assessing debt sustainability. Rather than setting arbitrary limits on a country’s debt-to-GDP ratio, the focus must shift to how debt is being used.
ACROSS Africa, macro-economic management has improved substantially in recent years. Studies by the International Monetary Fund, the African Development Bank (AfDB), and the World Bank, as well as surveys from Worldwide Governance Indicators and Transparency International, all attest to this trend. Yet concerns about debt sustainability on the continent have been mounting, especially since the onset of the Covid-19 pandemic.
Such worries are nothing new. By the 1980s and 1990s, African countries had amassed debt largely by borrowing from official creditors such as development banks, OECD export credit agencies, and Paris Club lenders (major creditor countries). This set them apart from Latin American countries, which had borrowed heavily from private lenders. Still, rising debt-sustainability concerns led to a wave of debt-relief programs from the late 1990s through the 2000s.
In 1996, the IMF and the World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative, which was followed three years later by the Enhanced HIPC Initiative. Both were major innovations in development finance that allowed for debts to multilateral creditors to be canceled. Then came the 2006 Multilateral Debt Relief Initiative and the rescheduling of sovereign debts through the Paris Club, which created a sense of optimism about the future of Africa’s debt burdens. Official creditors had extended more than US$100 billion in relief to more than 40 countries – some 85% of them in Africa.
More recently, the G20 established the Debt Service Suspension Initiative (in May 2020) and then the Common Framework for Debt Treatments (in November 2020) to help indebted countries deal with the fallout from the Covid-19 pandemic. Under these programs, all G20 and Paris Club creditors agreed to coordinate debt relief on a case-by-case basis to countries that applied for it.
The anatomy of African economies
Debates over sovereign debt often link indebtedness with poor governance or gross incompetence, as if debt is something shameful that any “good” government would seek to avoid. And yet, as Barry Eichengreen and his co-authors argue in their book In Defense of Public Debt, “governments’ ability to issue debt has played a critical role in addressing national emergencies – from wars and pandemics to economic and financial crises, as well as in funding essential public goods and services such as transportation, education, and healthcare.” More fundamentally, “the capacity to issue debt has been integral to both state building and state survival. Public debt securities have contributed to the development of private financial markets and, through this channel, to modern economic growth.”
While excessive spending and misuse of public funds have certainly been a problem in some African countries, the financial fragility found on the continent is mainly the result of balance-of-payments deficits caused by external factors. For example, recessions in the few advanced economies that import goods from African countries tend to have an outsize impact on the latter cohort’s fiscal position. These African economies are heavily dependent on the export of one or two primary commodities, and they have struggled to diversify their trade partners.
Higher global energy prices also tend to cut deeply into African public finances – including even in the major oil-producing countries, owing to their lack of refining capacity. Similarly, African countries are acutely vulnerable to commodity-price swings, dollar exchange-rate fluctuations, and rising interest rates in major economies (which can substantially limit their access to financial markets). All these factors are well beyond African governments’ control.
These problems are compounded by the continent’s rapid population growth, which is increasing demand for public services. Moreover, African countries have large infrastructure gaps. The AfDB estimates that the continent’s infrastructure needs amount to US$130-$170 billion per year, with a financing gap in the range of US$68-$108 billion.
Africa therefore has a good reason for its large external debt: it needs such financing to pay for major investments in infrastructure (energy, water, telecommunications, and road networks) and human capital (health care and education) required by the continent’s rapid demographic growth. Increases in public and external debt thus can be justified, especially if they go toward investments that will increase potential growth and attract more foreign direct investment (FDI).
A better way
The many debt-relief schemes implemented since 1996 have failed because they have all been based on a flawed framework for debt-sustainability analysis in Africa. The traditional DSA is a rather simplistic accounting tool that focuses solely on a country’s financing needs and its ability to repay – or what is misleadingly known as a country’s overall “balance sheet.” The problem with this approach is that it over-emphasizes external assets and liabilities encompassing both the public and the private sector.
Abiding by this definition of an overall balance sheet, the IMF and the World Bank have long focused on debt-related liabilities (as opposed to equity) and reserves. Their justification is that a country’s external debt and reserves have a significant impact on its ability to discharge external obligations – which may result from a problem of either solvency or liquidity – and thus will determine its overall debt vulnerability.
But a better approach is to move beyond a narrow, rigid understanding of debt sustainability to get a fuller picture of the determinants of indebtedness and debt-servicing capacity on the continent – especially in natural resource-rich countries. If solvency is defined as a country’s ability to meet the present value of its external obligations, a broader view of public wealth should be considered, in addition to granular assessments of public-sector balance sheets. This would allow for a comprehensive evaluation of what the state owns and owes, thus offering a broader and more accurate fiscal picture beyond debt and deficits.
Once governments understand the size and nature of public assets, they can start managing them more effectively, with the potential to raise considerable additional revenue. A deeper analysis of public-sector balance sheets also would allow for better risk management and policymaking. The IMF’s Fiscal Monitor already provides governments with the tools to analyze the resilience of public finances. By identifying risks within the balance sheet, they can take steps to manage or mitigate them early, rather than dealing with the consequences after the fact.
What has been missing
In 2018, the IMF and the World Bank finally acknowledged the weaknesses of their DSA framework, and introduced a new multi-pronged approach (MPA) that sought to strengthen debt transparency by working with borrowing countries and creditors to produce better public-sector-debt data and to mitigate debt vulnerabilities. The MPA also called for new tools to analyse debt developments and risks, and for reforms to the IMF and World Bank’s surveillance and lending policies to address debt risks and promote more efficient responses to debt crises.
The MPA represented a substantial improvement on the initial framework, but it still did not capture the specific economic identities of African countries. Since exports are these countries’ main engine of growth (owing to limited domestic demand), a realistic framework should account for the other macroeconomic and financial policies that are in place to boost external trade, promote economic and financial resilience, and reduce the volatility of export revenues.
Any DSA for Africa should place issues relating to external competitiveness and the appropriateness of exchange-rate policies at its core, to allow for a proper evaluation of national-currency overvaluation and devaluation in the medium term. Likewise, the analysis should consider a monetary policy’s capacity to provide a supply response in case of a currency devaluation.
DSA frameworks traditionally have not recognised the importance of the exchange-rate regime, even indirectly. While all countries should generally avoid excessive debt-service obligations, the risks and constraints are heightened for countries with a pegged exchange rate, especially when the anchor is a strong currency like the euro, which is the case for the 14 Sub-Saharan African countries in the CFA franc zone. For these countries, currency fluctuations have enormous implications for external debt, export revenue, employment creation, government revenue, and public debt.
Current analyses of debt sustainability do acknowledge the importance of reserves – which allow a country to absorb the shocks of curtailed or costly borrowing, boost confidence in its commitment to the timely discharge of external obligations, and support the value of its domestic currency. But even for countries with generally good macroeconomic management, a substantial volume of reserves is not a sufficient safety net in the case of sudden crises or financial contagion. Hence, a more effective DSA for African countries (and for developing countries more generally) would identify the critical element of their structural economic vulnerability – namely, their weak export structure (reliance on a few commodities and limited diversification of trade partners).
Finally, traditional DSA frameworks do not account well for security, even though this is a widespread issue on the continent, with significant macroeconomic implications. African countries at all levels of development are facing myriad security risks that carry major economic costs. While security budgets are usually state secrets, it is safe to assume that a substantial portion of fiscal revenue in many countries is now going to fight armed jihadist and rebel groups such as Boko Haram, Al-Shabab, and others.
These kinds of sustained security shocks incur heavy costs. Armed conflicts, civil wars, and terrorism destroy physical, human, and social capital, which in turn negatively affects production, trade, exports, consumption, and governments’ ability to collect adequate revenue to finance public expenditures. When military spending rises, social spending falls.
Armed conflicts are bad for business. They create unacceptably high levels of uncertainty (particularly for private-sector investment), fuel capital flight, and depress savings. Even after a conflict has ended, boosting investment remains difficult, because much of the necessary capital will have been damaged or destroyed. The harmful economic effects of conflict and war can last for years – or generations – undercutting growth and a country’s ability to service its debt. It is therefore critical that development-finance institutions devise new, credible financing instruments to support African countries confronted with exogenous security shocks, without worsening their capacity to service their debt.
New urgency
To be sure, concerns about Africa’s rising public-debt levels (both external and domestic) should not be downplayed or treated with complacency. Given the global rise of nominal interest rates and the heightened volatility and downward trends for commodity prices, African countries may find it difficult to service the debts they accumulated during the last expansionary period. As such, they will struggle to maintain the elevated levels of government investment needed to sustain growth and structural transformations in the years ahead.
But this means that complementing the traditional, flawed DSA approach with alternative methods has become an urgent priority. We need a new process that accounts for additional information on a country’s debt trajectory, and that offers new policy levers to address debt concerns – such as through exchange-rate adjustments or a rebalancing of public investment.
Given African countries’ serious infrastructure gaps, limited public services, and persistent security issues, debt will remain an indispensable financing tool. To the extent that it is used to fund productivity-enhancing public infrastructure, it can be fully justified. Under plausible assumptions, infrastructure improvements can increase growth enough eventually to decrease the higher debt-to-GDP ratio that results from the initial financing. The role that such investments play in boosting FDI – and the role that FDI then plays in boosting growth – should be considered fully in any DSA.
Development institutions and rating agencies should focus more on the quality and proper uses of debt to finance inclusive growth and essential investments. Rather than setting arbitrary limits on a country’s debt-to-GDP ratio, the focus of monitoring institutions such as the IMF and the World Bank should be on assessing whether increases in Africa’s public debt are being used for the right purposes – namely, public infrastructure. This alone would go a long way toward reassuring investors and decreasing spreads.
About the writer: Célestin Monga, a former managing director at the United Nations Industrial Development Organisation and a former senior economic adviser at the World Bank, is adjunct professor of public policy at Harvard Kennedy School and a former vice-president and chief economist at the African Development Bank Group.–Project Syndicate.
