Ethiopia’s Eurobond dilemma, the ripples of non-payment

On December 11, 2023, Ethiopia missed a USD33 million interest payment on its December 2024 dollar bond, marking the East African nation’s latest defaulter by emerging-market sovereigns and raising concerns about its once-promising economic future. This significant default, the first for Ethiopia after years of rapid economic growth, sent a shockwave through the international financial community and threatened to hinder the country’s future development prospects.

 Numerous discussions and articles have addressed Ethiopian officials’ rationale and market communication regarding the decision not to pay the first coupon on its one billion dollar 2024 Eurobond. The market perception of this official decision by Ethiopia, with credit default swap (CDS) serving as a valuable barometer of market sentiment in such scenarios, is explained in this article.

 A credit default swap (CDS) is a financial derivative that enables an investor to exchange or offset their credit risk with another investor’s. To mitigate the risk of default, the lender purchases a CDS from another investor who agrees to reimburse them in the event of borrower default. In government debt, investors utilize these swaps to express opinions about a government’s creditworthiness and safeguard themselves if a country defaults or undergoes a debt restructuring.

Examining the JPMorgan emerging markets bond index (EMBI), Global diversified Ethiopian Spread, the country’s risk premium surged from 3,000 basis points in June to nearly 6,000 by December 2023. Although the National Bank of Ethiopia (NBE) ‘s decision was rational and prudent, considering the challenges faced by other African nations in debt restructurings, it has not positively impacted the broader private investor and market perceptions of Ethiopia. This nation aspires to be a continental beacon as an investment destination.

This matters because the value of a country’s debts affects its ability to repay its liabilities and reduces the share of revenues for more productive uses. Specifically, if a nation struggles to fulfil its debt obligations over time, the sovereign risk will increase because of the higher probability of default. For this reason, an increase in public debt can lead to a rise in CDS spreads.

Furthermore, there are broader financial implications that sovereign entities may encounter if they default on their obligations. Governments may need to meet debt repayments to prevent more extensive consequences for the domestic economy associated with default, extending beyond the impacts of stricter terms and conditions imposed by foreign creditors. Various studies suggest that default often coincides with a reduction in output growth.

It does not help that internationally, Sub-Saharan African countries face penalties for default, actual or not. The interest rates charged to African countries compared to other emerging nations have been controversial and debated. The analysis of interest rates reveals a discrepancy that extends beyond credit ratings, suggesting a nuanced and complex landscape.

A June 2023 IMF paper shed light on the matter, pointing out that yields on Eurodollar bonds issued by African countries were consistently above five per cent. This high-interest rate occurred during meagre global interest rates, emphasizing the disproportionate borrowing costs faced by African nations. In contrast, the average interest cost of outstanding sovereign debt in advanced economies in 2021 hovered around one per cent.

This notable difference in borrowing costs becomes apparent when juxtaposed with regions like Latin America and Asia. While global interest rates were low, African bonds faced yields exceeding eight percent in 40Pct cases. This observation raises questions about the fairness of the risk premium applied to African sovereign debt.

 The IMF study delved into specific examples that underscored the apparent bias in interest rates. An intriguing case involved Argentina, a serial defaulter with nine to date. In 2017, Argentina issued a 100-year bond with a coupon of seven per cent, and to the surprise of many, it was oversubscribed. This scenario contrasts sharply with African nations, some of which have not defaulted in years yet face higher interest rates. For instance, Angola, which has not defaulted since the end of its civil war in 2002, was charged a rate of over nine per cent for much shorter-dated (30-year) bonds issued in 2018. Even its 10-year Eurobond issued in 2015 yielded 9.5 Pct.

The study suggests that credit ratings, while crucial, only partially account for the higher premiums African nations face. South Africa, an economic powerhouse, pays higher rates than Brazil despite having similar credit scores assigned by S&P Global Ratings. Similarly, Kenya faces higher interest costs for a 10-year dollar debt compared to equally rated Bolivia.

The disparities in interest rates result from the limitations of credit ratings in accurately reflecting the macroeconomic fundamentals and underlying risks in Sub-Saharan African countries. The more significant role of analysts’ judgments about political risks and the “willingness to pay” in these nations may introduce additional elements into the risk assessment process. This suggests that investors might be factoring in other risks beyond those reflected in credit ratings, leading to disproportionate borrowing costs for African countries compared to nations with similar ratings in other regions.

The international investor community’s sensitivity to perceived risks in Sub-Saharan Africa is higher than in other parts of the world. The issue could be linked to the limited linkages of Sub-Saharan African countries with global financial markets, making investors more attuned to financial developments and the risk of sovereign debt default in the region.

The interest rate differentials between African countries and other emerging nations highlight a complex interplay of factors, including global perceptions, historical biases, and the unique challenges African economies face. As efforts to attract foreign investment continue to grow, understanding and addressing these dynamics becomes crucial for creating a fair and conducive environment for Ethiopia and other African nations in the international financial landscape. Markets are not always rational; they are often influenced by emotions and sentiment, as evidenced by a historical review of market disasters spanning centuries and the IMF study.

Expanding on this, the implications of this decision for the efforts of the Ethiopian Securities Exchange (ESX) and Ethiopian Capital Market Authority (ECMA) in attracting foreign investors to the country are concerning. Roadshows do not necessarily aim to engage the already converted; they seek to attract new players, broaden the investor base, and support a more sustainable and robust growth model. Whether preventable or not, events like this complicate an already challenging task.

A Bank of England report further corroborated the IMF study, indicating that sovereign default is not always and necessarily linked to a loss of market access, but it does suggest an adverse impact on the government’s future borrowing costs. The need to preserve the critical aspect of the matter amidst the ongoing debate about the merits or demerits of non-payment is still an issue. The country’s liberalization efforts have become a more challenging sell.

The NBE has likely played what it perceived as a bad hand as well as possible, and it deserves commendation for attempting to avert the fate experienced by countries like Zambia. However, such trade-offs entail consequential collateral damage that may only become apparent later.

Since private creditors often consist of banks or other market-based lenders, their motivations diverge from those of multilateral or government agencies when extending loans to emerging nations. Private creditors operate within shorter and more constrained market-based environments, with their primary objective being the extraction of maximum returns on their cost of funds. Their decisions are guided by market economics rather than altruism, making this development less reassuring, as private funds tend to flow towards opportunities that promise the highest returns on investment. Private investment is always a flight risk, as it follows market dynamics. Whether positive or negative, sentiment pervades the financial landscape and only time will unveil whether the market continues to associate a high-risk premium with Ethiopia.

To learn more about how VXP supports Financial Service firms, please contact Michael Okwusogu, Managing Partner, Head of Financial Services.

12th Year • January 16 2024 – February 15 2024 • No. 125

Michael Okwusogu

Is a strategy and operational excellence professional with over 20 years’ experience in Global banking, capital & financial markets. He is, Managing Partner, is Head of Financial Services at Value X Partners.

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