Debt stress has always been a contentious matter in Ethiopia. As the country pursues billions of dollars worth of infrastructural development projects, external debt stock has been growing proportionally, now accounting for almost 30Pct of the GDP. While the risk to debt sustainability escalates, several challenges limit the prospects for bucking this trend. This includes the wide gap between investment and savings, and the underperformance of the export sector. With such factors in mind, the International Monetary Fund (IMF), changed the debt stress rating of Ethiopia from moderate to high recently, hinting that the chance of defaulting on loans is increasing. Although the government is able to take corrective measures such as refraining from taking commercial loans, experts say that is too late. EBR’s Samson Berhane spoke to government officials, macroeconomists and financial analysts to probe into the matter.
Ever since Ethiopia began the first phase of the Growth and Transformation Plan (GTP I) in late 2010 with rather ambitious targets, the country has been dependent on external borrowing to bring about growth and productivity improvements in the manufacturing sector and infrastructure development. After constructing railway networks, cross-country roads, industrial parks, and multiple sugar and fertilizer factories, the country, which is trapped in a quagmire of mega projects, has been sinking into external debt.
Ethiopia’s external debt stock increased by a whopping 207.6Pct from USD7.8 billion in 2010 to USD24 billion in September 2017, which is 40Pct of the gross domestic product (GDP), according to the Public Sector Debt Statistical Bulletin published by the Ministry of Finance and Economic Development in December 2017. Adding in domestic debt, which currently stands at USD22.6 billion, shoots the debt figure to 57Pct of the GDP. Although investment has increased extraordinarily from a weak base, the most decisive aspects of the first and second phases of the GTP have yet to materialize. In fact, the mounting external debt has increased the country’s vulnerability.
The swelling appetite of the government for growth has worsened the external public debt stress rating of Ethiopia from moderate to high risk in early 2018, signaling the country’s low capacity to service its debts unless it takes preventive measures. The International Monetary Fund (IMF) rates external public debt stress at four levels: low, moderate, high and in debt distress. If countries with high debt risk ratings don’t become more self-reliant while undertaking heavy infrastructure and social development projects, they won’t be able to avoid the risk of a debt trap, according to IMF.
Atlaw Alemu (PhD), head of the economics department at Addis Ababa University (AAU) with 16 years of experience, shares the IMF’s assessment.“Most projects constructed using commercial loans do not pay off in the short term. Their return on investment is very low,” he said, citing the railway projects, power generation projects and industrial parks constructed over the past four years. “The payment period of the loan is short and the interest is very high. It is not clear why the government keeps taking non-concessional loans.”
There are two forms of external public borrowing: concessional and non- concessional loans. Concessional loans are provided with low interest rates or longer grace periods than normal market loans. According to the IMF, concessional loans have average interest rates of 1.3Pct, maturity of 30.3 years and grace periods of 5.7 years. On the other hand, non-concessional loan are provided at market-based interest rates.
The structure of debt in Ethiopia is such that it is largely made up of concessional credit. Out of the total external debt, 63Pct is non-concessional loans accessed from bilateral sources and private creditors. As a result, risks have increased, according to the Debt Sustainability Analysis conducted by the IMF in 2017. This is because debt service indicators have deteriorated, mostly because of export underperformance, even if Ethiopia’s debt leverage remains unchanged from 2016.
Admasu Nebebe, state minister for Finance and Economic Cooperation, however, stands against the IMF’s assessment. “It is a short term problem and is not going to have an impact on pending projects,” he said. “The country is in a good state in all parameters that measure the debt stress of a given country, except for export.”
Is Ethiopia’s External Debt Sustainable?
Based on the Country Policy and Institutional Assessment conducted in 2015, which classified Ethiopia as a medium performer, the minimum thresholds for achieving debt sustainability are set at 40Pct, 250Pct and 150Pct of the present value of debt-to-GDP, debt-to-domestic revenue and debt -to-exports, respectively. The IMF’s Analysis, which shows Ethiopia’s projected debt burden over the next 20 years, taking into consideration normal and extreme circumstances, reveals that the present value of debt-to-GDP stood at 22.6Pct in 2016/17, well above the minimum threshold. This trend is expected to continue for the next 20 years.
Yet experts stress that given the size of external debt in relation to the country’s GDP, the economy is unlikely to produce sufficient revenue to pay back loans without incurring further debt. “Such rates would exist in a country where the government is a powerful and dominant player, and the private sector is not vibrant,” explained a macroeconomist with two decades of experience.
Nonetheless, Tyler Cowen, a professor of Economics at George Mason University, is not overly concerned, alluding to the case of Singapore, which was once labeled a high risk country with a debt to GDP ratio of over 100Pct, but managed to repay its debts despite the IMF’s projections. “The rise in debt to GDP ratio might show the risk is higher, but it does not matter,” he said, during a press briefing held at the US Embassy in Addis Ababa last month.
Irrespective of the swell in the ratio, it is possible for Ethiopia to remain unharmed, according to Cowen. “The question should be whether the debt outraces the growth or vice versa. Reducing additional borrowing while focusing on debt servicing can help Ethiopia remain intact,” he added.
Alemayehu Geda, professor of Economics at AAU, is amongst those who believe the debt-to-GDP ratio might not accurately show the country’s debt stress risk, but he takes a different perspective. “As Ethiopia’s GDP is overstated due to various estimation errors, the ratio is even higher than the current figure, which signals that the chance of default is higher. This will adversely affect the country’s credit rating and record,” he said.
Just like the present value of debt-to-GDP, the current value of future debt-to-revenue ratio will remain below the minimum threshold in the next 20 years under normal and extreme circumstances, according to Debt Sustainability Analysis. In 2016/17, it stood at 141.7Pct, 73 percentage points lower than the threshold.
But when it comes to the second indicator: present value of debt-to-export ratio, the ugly truth is uncovered. Even assuming all variables remain constant in the future, the present value of debt-to-export ratio begins to surpass the benchmark in 2017/18 with 271.9Pct, which is 121.9 percentage points above the threshold. IMF projections show that the ratio will only fall below the 150Pct threshold in 2021/22.
Even worse, the ratio, which is already above the threshold under normal circumstances, exceeds the threshold under extreme conditions for the next nine years. Dependency on only a few export commodities, coupled with low export revenues, makes Ethiopia especially vulnerable to export shocks, according to the IMF.
“Had we achieved export earnings targets, the sustainability of external debt would never have been an issue,” argues Admasu, explaining the importance of exports in determining debt sustainability.
At the end of the GTP I period in 2014/15, the share of exports to GDP at current market price was targeted to reach 31.2Pct from 10.5Pct in 2009/10. In absolute terms, the plan was to increase export earnings from USD2 billion to USD6.5 billion within five years. However, the actual achievement fell short of the target, and annual export earnings barely surpassed the USD3 billion mark.
During the ongoing five-year plan period, the export sector has remained sluggish, despite the government’s plan of increasing foreign exchange earnings from merchandize exports from USD3.1 billion in 2014/15 to about USD13.9 billion in 2019/20.
None of the various measures taken by the government to promote exports have brought about much needed change. Even the 15Pct devaluation of the local currency in October 2017 against the basket of major foreign currencies did not provide a cushion, as data obtained from the Ministry of Trade indicates. In the first three quarters of the current financial year, the country’s export revenues were around USD2.1 billion, showing a meager four percent rise compared to the same period last year.
On the other hand, imports reached almost USD17 billion in the last financial year, resulting in a trade deficit of USD14 billion. On top of this, more than half of the country’s export commodities are agricultural products, which have unstable prices in the international market. Thus, the trade deficit is expected to widen as the prices of agricultural commodities face a predicted decline.
“There is a big implementation gap,” argues Atlaw. “There is no entity tasked with promoting and following up the export sector. Establishing a separate body would have helped the country to integrate services provided to exporters, and it would play a major role in minimizing the role of intermediaries and encouraging exporters.”
But for the moment, the export sector, which has always been volatile, throws the sustainability of external debt in Ethiopia into question. Even adding the foreign earnings that come in the form of remittances doesn’t reduce the vulnerability of the country to the mounting external debt.
In Ethiopia, remittances are becoming the major source of foreign currency reaching USD4.4 billion in 2016/17. The share of remittances in GDP stood at 5.5Pct in the same year, well above exports, which accounted for 3.6Pct of GDP. Yet the present value of the debt-to-exports-plus-remittances ratio continues to breach its threshold. The violation of the minimum thresholds even after adding remittances paints a grim picture about the debt sustainability situation in Ethiopia.
Impact on Economic Growth, Private Sector
Scholars like Catherine Patillio, a strategist at the World Bank, who examined debt sustainability by studying the experiences of 61 developing countries, stress that external debt has a positive impact on economic growth. Since developing nations have small capital stock and low levels of saving at the early stages of their development, external borrowing can help to bridge the financial gap, according to Patillio.
Likewise, when Ethiopia embarked on an ambitious five-year plan in 2010, the share of domestic savings in relation to GDP was 9.5Pct, while the investment rate was around 23Pct of GDP. The gap between the two forced the government to lean on external borrowing, partially to invest in growth enhancing sectors such as infrastructure and social sectors. Seven years down the line, however, the gap between savings and investment remains wide. Last financial year, domestic savings to GDP ratio stood at 24.1Pct, while investment to GDP ratio reached 39Pct.
Although the huge gap between saving and investment indicates that the government is likely to continue with its previous style, officials stress that the government will not go beyond a level that surpasses the country’s debt repayment ability. “We have set a threshold for each state-owned enterprise (SOEs) that wants to take commercial loans from various sources,” explains Admasu. “Contrary to the previous approach, a new committee that approves or rejects the debt proposal of any government institution and SOEs was established by the MoFEC.”
However, another macroeconomist who has spent three decades in the field believes such measures won’t be fruitful in the short term. “The measures should have been implemented before the crisis,” he said.
One of the important conditions for external loans to have a positive economic impact on a credit receiver country is to guarantee that the marginal productivity of each external loan, at least, is greater than the cost of the principal and interest repayment, according to Patillio. This condition requires that the external loan is in productive sectors that improve the productivity of other sectors, so that external debt servicing will not hold back the borrower’s economic growth.
But if external credit is invested in an unproductive way, the expected gains from external loans will be much less than the cost of borrowing, which is the case in Ethiopia. One case in point is the sugar development project started by the government seven years ago. Despite none of the factories having started operation, Ethiopia is being forced to spend a significant amount of hard currency to service its debt. In face, in the past two years, the country has spent USD1.2 billion annually to repay its debt.
For the macroeconomist, negotiating with debtors for rescheduling would be helpful until the projects start paying off. Such an approach, however, would be tough for Ethiopia, according to Alemayehu. “The expensive loans taken from China do not only impact debt servicing, but also on the country’s sovereignty,” he remarked.
China, whose financing model is very different from the traditional aid programs of European countries and the United States, is the main bilateral partner of African countries, providing billions of dollar of concessional loans. Between 2000 and 2014, more than USD59 billion was provided by the Chinese Exim Bank to finance African governments and state-owned enterprises.
Yet Admasu is still hopeful. “Despite the challenging situation, the country is very capable of fulfilling its debt obligations properly. Meanwhile, the industrial parks built across the country will bolster export proceeds, and increase the potential of the country to repay its credits.”
In spite of officials’ optimism, the adverse impact of the debt stress is starting to be seen. The World Bank limited Ethiopia’s non concessional loan borrowing to below USD400 million starting in March 2018. Even members of Parliament voiced their concerns about external debt management during a session held last month. “The effectiveness of the loan financed projects must be checked. The reality might be different from our expectations. We might be passing a heavy debt burden to the next generation,” Mesfin Chirnet, an MP from Southern state said, when an aggregate of one billion birr worth of loan agreements with the World Bank was tabled before Parliament for approval.
Experts are also certain that the swell in debt stock will leave a scar on the economy. “Unless the government postpones the mega infrastructural development projects, it will be exposed to debt [stress], whether external or internal,” argues Alemayehu. “The problem would turn into a vicious cyle.
The other impact of increasing external debt is its constraining effect on liquidity, which is caused by channeling limited export earnings to service external debt instead of using it to raise the productivity of private investments. Indeed, the external debt crowds out the private sector.
“Coupled with the existing crisis, servicing debts might spur a rise in taxes, which would discourage investments and crowd out the private sector,” explains Alemayehu. “It will also erode the inadequate hard currency available for imports and adversely affect businesses and investment projects that are dependent on imported goods.”
Abdulmenan Mohammed, a senior financial analyst in London agrees. “Increased government demand for foreign currencies for the repayment of debts and interest has affected the forex operation of the financial sector. A widening budget deficit due to excessive debt repayment forces the government to scramble on the financial resources of the commercial banks in competition with private sector.” EBR