The Dangers of Ethiopia’s Rising Domestic Debt

Ethiopia, along with countries like China and Bangladesh, is one of the fastest growing economies in the world. The second African most populous country achieved a commendable economic trajectory in the last two decades. Although the rate is a subject of debate among scholars and policymakers, the government claims an average of 9.9Pct growth was achieved in the past 10 years. This was corroborated by the various mega construction and other major infrastructural projects implemented during the period. Though this has helped the country achieve the title of ‘African Tiger’, it has piled up the country’s debt, both external and domestic. EBR’s Kiya Ali explores the dangers of domestic debt piles.

Although the Ethiopian government has failed to meet its extremely ambitions plan of the first and second Growth and Transformation plans (GTP), it launched in the past fiscal year the costly Home Grown Economic Reform Programme that needs USD10 billion. The Home Grown Economic Reform Programme is a three year plan that focuses on structural changes and reforms in different economic sectors to boost the economy and pave the way for job creation, poverty reduction, and balanced regional growth by resolving the problem of macroeconomic imbalances.

Ethiopia borrowed USD2.9 billion from the IMF to finance part of the reform plan. That made the total public sector debt of the country stand at USD53.4 billion as of December 31, 2019. The public external debt amounted to USD27.7 billion of the total public sector debt while public domestic debt stood at USD25.7 billion, according to the Public Sector Debt Statistical Bulletin published by the Ministry of Finance in March, 2020. Out of the total public domestic debt, the share of the central government was 52Pct while the remaining 48Pct was owed by State Owned Enterprises (SOEs) like Ethiopian Electric Power (EEP), Ethiopian Electric Utility (EEU), Ethiopian Sugar Corporation (ESC), and Ethiopian Railways Corporation (ERC). The figures indicate that in addition to external debt, the country, which has invested a lot on mega projects that are sluggish in progress and have low return on investment, is sinking into a huge domestic debt trap.

Domestic debt covers the debt of the central government in the forms of government bonds, treasury bills, direct advance from the central bank, Corporate Bonds, and long and short term loans owed by SOEs. Among them, EEP takes up the front row in terms of its indebtedness because of its huge investment on the construction of power plants including the Great Ethiopian Renaissance Dam (GERD). EEP’s heavy capital investment has increased the country’s power generation capacity from 2,000MW in 2010 to 4,300MW in 2018. The goal of the five year plan implemented between 2010/11-2014/15, the first Growth and Transformation plan (GTP 1), was to increase the installed generation capacity from 2,000MW to 10,000MW primarily through hydropower projects.

Under the five year plan that followed it, GTP II, EEP planned to generate additional 5,000MW by 2022. To finance its projects and achieve the goals set in GTP II, EEP issued corporate bonds of ETB112.3 billion to Commercial Banks of Ethiopia at an interest rate of six percent. However, EEP was not paying its debt semi-annually as per its contractual agreement. The result is arrears in tens of billions of birr.

However, Public Relations Director of EEP, Moges Mekonen stated that EEP doesn’t have a debt with an approaching maturity date or one that is become beyond its capacity to service. Moges further noted: “Genale Dawa hydroelectric power generation project, which has the capacity of generating 245MW of power, was inaugurated and started to generate four million birr per day. Moreover, EEP generates USD55 million per year on average by selling power to Djibouti and Sudan. EPP will also start to export power to Kenya by the end of the year. As we have not started new projects over the past two years to focus on the finalization of existing projects, EEP is not facing difficulties to service its debt.” Moges is, however, still concerned about settling the joint debt owed by EEP and EEU before the split of the Ethiopian electric power corporation in 2013 into EEP that is responsible for generation and transmission of power, and EEU that is responsible for power distribution. The involvement of the Ethiopian Electric power corporation in short term loans and low tariffs of USD0.02/kWh was responsible for the huge debt burden of both utilities. In addition to EEP, other SOEs have also taken massive loans from the Commercial Bank of Ethiopia (CBE). “These loans have exposed the CBE to huge credit risks and maturity mismatch as the CBE mobilizes current and short-term savings,” said Abdulemenan Mohammed, a financial expert.

Limited mobilization of domestic financial resources was one of the implementation challenges encountered during the first and second GTP periods. Of course there was an improvement and increase in the generation of domestic revenue, particularly tax revenue, over the years as a result of administrative measures taken to reform the revenue collection structure. Compared to the requirements of the development programs of the country, however, the revenue generated still remains low.

One of the constraints that make adequate resource mobilization difficult was the low level of domestic savings. The rate of saving has declined in recent years, despite the aggressive measures taken by commercial banks to expand branches with the motive of expanding financial inclusion and increasing the mobilization of savings. Compared to figures for the previous year, for instance, a report by the National Bank of Ethiopia (NBE) shows that the growth rate of saving deposit declined from 30.4Pct to 27.4Pct in the 2018/19 fiscal year. During the same time, time deposit shrank from 21.7Pct to 17.8Pct and demand deposit decreased from 36.3Pct to 11.4Pct.

Sluggish progress of mega projects and low return of finalized projects that were financed partly by domestic debt in collaboration with low domestic savings created credit constraints for private investors who need finance to support the huge demand of private investment required for the country’s accelerating growth and development. “The sluggish progress of projects put considerable strain on the CBE as more funds are required and existing loans are not being paid according to the terms of the loan agreement. Furthermore, excessive government borrowing from the banking system has a crowding out effect. It deprives private sector funding and increases the cost of borrowing,” Abdulemenan remarked.

Ayele Gelan, an economist, pointed out crowding out as the most damaging effect of high domestic debt on private businesses. “Domestic debt has numerous direct ramifications, including unnecessarily high interest rate,” he noted. Alemayehu Geda, a Professor of Economics at Addis Ababa University, on the other hand argues that the current level of domestic debt doesn’t have a huge impact on private investment. “The government is currently focusing on the private sector. So, what is more worrisome is government political lending and perhaps domestic and foreign private sector get proportional and biased to domestic share,” Alemayehu argued.

The 2018/19 NBE report shows overall fiscal deficit (excluding grants) of ETB101.7 billion compared to ETB84.5 billion deficit last year. In the face of such public deficits, any government is always confronted with the choice between external and domestic financing. In the short-run, public debt has a positive effect on the growth and development of the country by triggering demand and increasing productivity. In the long run, however, the positive effects may turn into negative consequences, if things don’t go according to plan. The mega projects in Ethiopia can be a case in point.

“The ambitious governmental goals for economic growth and development led to the launch of numerous projects without due attention to their financing sources. The goal was financing the projects by any means possible. The other side and the opportunity cost of financing these projects from domestic and foreign debt has not been examined properly,” explained Eyob Tesfaye, a macroeconomist with decades of experience. “Some of the projects are finalized but their return on investment is low while other projects are still under construction and incur the government additional cost as they have taken extended time,” he added. Extension of project period leads to increase in the cost of imported materials, exacerbation of problems associated with devaluation of local currency and shortage of foreign currency.

Moreover, Ayele stated government defaulting on payments as another challenge of high domestic debt. “This has happened to the Commercial Bank of Ethiopia (CBE) and the Development Bank of Ethiopia (DBE) time and again. 40Pct bad debt is unheard of in the normal banking history of any country,” Ayele noted.

Unlike foreign debt that can increase a country’s access to resources, domestic borrowing is only transfer of resources from one sector to another within the country. So, the underperformance of a partially or fully domestically financed industrial sector due to inadequate technical and managerial skills in the sector, foreign exchange shortages to import essential raw materials, spare parts and other inputs, and power disruptions leads to inequalities in inter-regional growth by creating scarce financial resources for other regions. “In addition to inter-regional inequality and crowding out, government debt adversely affects the structure of the economy. Had the private sector borrowed the money, they would have invested it in activities that are different from those of the government’s and this would have deeper implications in terms of structural transformation of the economy. In the worst case, government borrows to finance final consumption rather than capital expenditure,” Ayele stated.

High inflation is another consequence of high domestic debt by the federal government, if it is not invested on productive projects that have a potential to return its debt before or on its maturity date. So the high level of inflation, 21Pct as of February 2020, is partly associated with government expenditure on less productive sectors. “The government was supposed to focus on financing sectors in which the country has competitive advantage, such as agriculture as it would help reduce inflation by producing more food items. In addition, it has the capacity of employing a large amount of labor that will decrease the level of unemployment. It will also boost export earnings as the items we export are fundamentally agricultural.

On the contrary, the industrial parks are still supplemented by more than ETB100 million a year let alone generating income. This has a spill over effect. If the industrial parks don’t generate enough foreign currency from export and return the amount invested to build them, the government will use its revenue to service its foreign debt and print money to settle its domestic debt. That will have an inflationary effect,” elaborated Wasihun Belay, an economist. During the time of dissaving as a result of business slowdown, political instability, and an increase in unemployment rate, delay of domestic debt payment will push CBE into a liquidity crisis, as per Wasihun.

Muluneh Aboye, Credit Management Director at CBE, stated that they provide SOEs with credit after studying their financial capacity. “Moreover, we believe that the organisations will service their debt since the government is the one who guarantees the loan. But there might be a delay,” explained Muluneh. “Government projects have almost ceased and the government is now emphasizing the liberalisation and privatisation of various sectors by putting up organisations like sugar factories for sale. So, we believe that the economy will become private sector led and it will help the organisations to service their debt before or on its maturity date,” Muluneh added. On the other hand, loans from the NBE have no maturity date. “Large portion of the domestic debt of the federal government belongs to the national bank, which has no maturity date. This debt is one of the main causes for uncontrollable inflation as the loan from the central bank is the same as money printing,”Abdulemenan argues.

For Alemayehu, the current level of domestic debt is not healthy for three reasons. “First, the amount of domestic debt is already 50 to 60Pct of GDP. But this is misleading. If it is taken as percentage of exports, which shows ability to pay, it is >1000Pct and the export growth in the last 3 years is zero and below zero. Despite such conditions, the government has been borrowing from various sources over the last 2 years. This heavy borrowing can be alarming if the mechanisms of paying back the debts are not considered beforehand. The country currently has a pledge of over USD10 billion of foreign debt. So, to avoid debt crises, it may prioritize servicing foreign debt instead of domestic debt. The Final reason is that Ethiopia’s GDP is exaggerated. In my view, it is not more than USD60 billion; that makes the debt to GDP ratio over 100Pct. However, the government claims that it is 60Pct. Moreover, the most relevant financial ratios, such as deposit to debt ratio, are in bad shape at banks,” explained Alemayehu.

In general, if domestic debt is not managed properly, it will have adverse impacts on the economy by leading to high inflation, lower investment by the private sector, higher cost of borrowing, and increased credit and liquidity risk to CBE. “Besides, the burden will roll over to the younger and/or the future generation,” Ayele stated. To avoid these adverse effects, Abdulemenan suggested financing of mega projects from multiple sources and ensuring proper execution of projects as it will make loan repayment smooth. “There should also be a ceiling on the amount of funding a new project can get from the CBE and the credit exposure of the CBE should be monitored closely. The other point is to finance budget deficit, a properly functioning treasury bills market should be created and borrowing from the NBE should be stopped gradually,” Abdulemenan suggested.

For Ayele, however, the best thing the government can do is encourage private sector borrowing so that the private sector would thrive and the tax base would broadened. “In the short run, the government must regulate the banking sector and reduce interest rates on loans to the private sector. Private banks lend at about 16 to 18Pct of interest and have declared 20 to 40Pct dividends over the last 20 years. It’s crazy economics that leads to vicious cycle. As a result, only a few investors in the banking sector are benefiting while the rest of society suffers.

Therefore, interest rates should be reduced on loan to promote private investment and reduce government expenditure,” Ayele recommended. Focusing attention on the agricultural as it is the area where Ethiopia has competitive advantage, attracting more foreign direct investment by raising the ease of doing business, rendering attention to tourism and mining sectors, and prioritizing sectors that contribute significantly to GDP for public financing are Wasihun’s recommendations. “To accomplish projects successfully, furthermore, proper feasibility study has to be conducted on the viability, potential of return on investment and source of financing of all projects.

Project management and contract management are also essential elements. Moreover, using public private partnership, joint venture and giving the project to building operators could be a good alternative for project financing,” Eyob concludes.EBR

9th Year • August 1 – 15 2020 • No. 89

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