Dead Aid: Why Aid Is Not Working and How There Is a Better Way for Africa

by Moyo, Dambisa

  Moreover, as economies have stabilized, and operate under better management, investors themselves have evolved from more short-term speculators (jumping in and out to garner short-term gains) into longer-term players happy to buy and hold developing-country assets for longer periods, and even up to maturity.

  While it is true that the Asian crisis of 1997, the Russian debacle in 1998 and the Argentinian default of 2001 all led to a sudden outflow of capital from the emerging markets, these proved to be hiccups in what has been a strong and growing trend of emerging-market interest. And even in those countries where money flowed out on the back of crises, in just one decade investor money has returned.

  The reasons for the rapidly growing interest in emerging economies are threefold:

  For one thing, investors are always looking for the next, best opportunity. And emerging-market fundamentals make a strong case for being some of the best opportunities around. Countries that exhibit strong economic performance and are seen to be on a sound and credible footing will be rewarded. At a minimum, foreign investors will be willing to lend the country the cash. However, the beauty with bonds is that their very existence lends further credibility to the country seeking funds, thereby encouraging a broader range of high-quality private investment. More credibility equals more money, equals more credibility, equals more money and so on. As part of the macroeconomic improvements, being actively seen to be making strides away from aid, and in doing so shaking off the stigma of being an aid ‘basket-case’, is in itself an attractive proposition to potential investors.

  Second, unsurprisingly, investors are attracted to the prospect of high returns. At the most elementary level, fund managers and commercial banks are themselves rewarded for a decent appreciation on their capital. In some cases, dedicated emerging-market fund managers (those only investing in these markets) look for net returns of at least 10 per cent per annum. By and large, thanks to their rapid growth, and the relative scarcity of investment capital, it is mainly assets in emerging markets and underdeveloped countries that can deliver these high returns.

  For example, in 2006, emerging-market debt gave investors a return of around 12 per cent. The performance beat the 3 per cent return for US government bonds in the same year. Moreover, emerging-market debt has almost consistently outperformed international stocks over the past ten years. Whereas the average return for emerging-market bond funds over the past five years has been 40 per cent, US equity indices have only returned 20 per cent. In 2007, emerging-market bonds returned some 35 per cent and J. P. Morgan’s EMBI+ index of such bonds performed better against American government bonds by 15 per cent. Over a longer timeframe – say an eighteen-month to two-year window – experienced portfolio managers can make significant returns, averaging 25–30 per cent per annum.

  More generally, historically, choosing to invest in the bonds of relatively underdeveloped economies instead of home bonds has paid off. The evidence of ten countries suggests that investors made higher returns on bond lending to foreign countries than in safer home governments; despite the former’s wars and recessions, foreign bondholders got a net return premium of 0.44 per cent per annum on all bonds outstanding at any time between 1850 and about 1970.

  Third, investing in the broader class of emerging markets can enhance portfolio diversification. The notion of portfolio diversification is at the core of asset management. It pertains to the need to spread your risks and rewards across investments. In essence, you diversify a portfolio to garner the same amount of returns for a reduced amount of risk. A very basic example of the diversification concept is illustrated by two separate islands, one that produces umbrellas and another that produces sunscreen. If you were to invest only in the island that produces umbrellas, you would make a fortune when it was unseasonably wet, but you would do poorly when it was a very dry year. Conversely, were you to only invest in the island that manufactures sunscreen, you would make a killing in the year when rainfall was extremely low, but would fare poorly if it were a very wet year. However, an investment in both islands could ensure you made money regardless of the climate, thereby reducing the risk to your investment (and, of course, to your expected return).

  In a similar vein, portfolio managers look to spread their risk and maximize their returns by choosing across a wide variety of options. Emerging economies (and African investments as well) offer a way for portfolio managers to improve their performance.

  Like the sunscreen and umbrella islands, emerging markets and developed markets are so disparate that the opportunity to enhance a portfolio’s performance by having some exposure to both markets is considerable; smoothing out the risks and enhancing the returns.

  In the past, research has found that emerging-market debt (broadly as a group, as well as for individual countries) has low (and sometimes even negative) correlations with other major asset classes. To put it simply, emerging-market investments tend to fare well when other asset classes (say, developed-market stocks and bonds) fare less well. Indeed, the correlation of key emerging-market spreads (the difference between the risk-free rate and the rate charged to a riskier concern) and US bond returns is typically negative – moving in the same direction when the global economy is universally bad.

  Emerging-market debt has the advantage of being countercyclical to the developed business cycle, since, in a global recession, poor countries can find it cheaper to repay their debts. As global interest rates decline, which often occurs on the back of a global economic slowdown, the debt service costs for poor countries (denominated in the foreign currency) goes down.

  Differences in economic fundamentals between developed and developing countries also provide support for the diversification argument. Emerging-market debt also benefits from high oil prices. Although oil price shocks may induce a global economic recession (recent oil price heights have so far defied this assumption), the counter-cyclicality of emerging-market debt – the fact that oil-producing countries may fare well when oil prices rise – means emerging-market assets can help protect a more diversified portfolio.

  There is an additional factor that can drive demand for the bonds of well-run African countries. Very often, international investors have restrictions on what they can and cannot buy for their portfolios. For example, some pension funds are only allowed to buy securities (stocks or bonds) which are included in approved lists (indices) drawn up by rating agencies or investment banks (for example, the J. P. Morgan Emerging Market Bond Index). Like in football or other sports, these indices are in effect league tables in which countries can go up or down, be included or excluded depending on their overall performance and their liquidity (that is, how easy it is to buy and sell the security). There is, therefore, always constant movement (South Africa, South Korea, Mexico and Brazil each have moved to higher levels of the credit league tables), and, more importantly, there is always room for new entries.

  Likewise, sometimes countries leave willingly, and sometimes they are forced out.

  As countries mature they may choose to reduce the number of bonds they issue in the international market in favour of domestic bond issues or relying on domestic savings and tax. South Africa is one such example. Over time, as its issuance of international bonds declined, its position in the J. P. Morgan EMBI league table fell, and eventually it was dropped. In another case, when Argentina defaulted on US$132 billion of its debt in 2001, it was also removed from J. P. Morgan’s index.

  Not every investor uses league tables. For those interested in taking great risks the league tables may not matter. However, for more risk-averse investors league tables matter a lot. The point is, league table or no, there is a huge untapped market available for those African countries that choose to put themselves forward. Clearly the fluidity in these league tables is an obvious opportunity for African countries to raise their game and get on them.

  Furthermore, by graduating onto such a bond index, greater name recognition and investor familiarity could improve liquidity and ove
r time reduce a country’s cost of borrowing from the international markets; another perk for being responsible and growing up. Today the total amount of hard-currency emerging-market government debt is approximately US$100 billion, and as much as US$3 trillion market trading per day.

  But there are challenges. History and experience have taught us that.

  As mentioned earlier, in order for borrowers (countries or companies) to access bond investors, they need a credit rating. That is the first hurdle that needs to be jumped; their credit rating determines which investors a borrower gets to see and the cost of borrowing. For the most part, there are three recognized major rating agencies that investors look to: Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. Their role is to assess a potential borrower’s ability (mainly the country’s likely future income path based on economic and social factors) and willingness (essentially a political assessment) to repay any debt. On this basis countries are ranked from triple A to triple C – essentially bankrupt.

  But rating countries and companies is an art not a science, and rating agencies have been known to get it wrong – sometimes spectacularly, as in the case of Enron, which had received a clean bill of health (rated a solid investment grade Baa3 by Moody’s) just five days before the company filed for bankruptcy. In May 2008, the rating agency Moody’s was reeling from revelations that the company had allegedly awarded incorrect ratings to securities worth at least US$4 billion because of a bug in its computer models. Although this debacle centred on rating agencies’ role in rating complex (derivative) structures, rather than traditional models used to rate sovereigns and large corporates, it is clear that no one is infallible.

  If a country is awarded a better credit rating than it deserves, it has little to complain about. But the reverse can happen, and this would be felt in the interest rate that the country would face upon borrowing.

  A country’s ratings are not only important for its own ability to issue debt, but also dictate the rating for companies within its borders. The notion of a sovereign ceiling means that a company can never obtain a credit rating higher than that of its country. In places where a country has no rating the ability for companies to seek outside investment capital is hampered greatly.

  Another challenge is contagion. This is the misguided idea that all emerging countries are tarred with the same brush, and that if one defaults then inevitably all others in the same category, regardless of their unique situations, will follow suit.

  The 1997 East Asian crisis is an illustration of this. Although the financial problems were initially confined to the East Asian economies, countries such as Brazil, where the stock market fell by 24 per cent, and South Africa, where it fell by 23 per cent (both in dollar terms) over the same period, also felt the pain. The Mexican tequila crisis of 1994 and the Russian flu of 1998 are other examples of how the international markets’ negative reactions to one country spill over and unfairly penalize other countries.

  In theory, the risk for an African government is that it could be susceptible to its neighbours’ bad news and, without notice, investors could take their money out, leaving a country cash-strapped. With the bond markets effectively shut, a country’s carefully scripted economic plans can be suddenly placed in jeopardy, through no fault of its own. During the East Asian crisis the average cost of borrowing for an emerging market rose by as much as 60 per cent.

  The good news is that international investors no longer view the markets in such a uniform way. As investors have become savvier, the notion of contagion risk has largely diminished. When Argentina defaulted in 2001, the repercussions elsewhere were insignificant. Borrowing costs money, and some forms more than others. This is a challenge African governments must face up to.

  For most poor countries, the obvious financial choice is to go for the cheapest option – that is, aid – but because of the fine print this often proves to be a costly choice. The realities of borrowing are much more nuanced. While it will always be financially cheaper for them to borrow from the World Bank and other concessionary lenders, factoring in other costs suggests a more punitive deal.

  It all adds up. The status quo of aid-dependency guarantees reputational damage. Ever-present corruption and the negative stigma left in the minds of potential investors (another African begging bowl) are part of the hidden costs when countries access ‘cheaper financing’. How much better if a country pays the higher financial rate, and gets quality investment and an improved standing in the world?

  The average cost for an African government to draw down on a World Bank loan under its concessional window is around 0.75 per cent. The average cost for an emerging-market country to issue debt in 2007 was 10 per cent, but has been declining.

  In just ten years, emerging-market spreads – that is, the premium developing countries have to pay in addition to the borrowing cost of a risk-free borrower (say, the United States government) – shrank from 30 per cent to a record low of 5 per cent in 2006. The narrower spread means a country issuing debt now saves an average of about US$90 million a year in interest for every US$1 billion compared to debt issued in 2002.

  Why have the costs of borrowing come down? Two reasons: first, notable improvements in different countries’ macroeconomic and political environments. Second, improved liquidity (save perhaps the mid-2008 credit crunch); that is, more cash chasing developing-country assets. The net result is that developing countries’ assets become more attractive, and the increase in demand helps lower costs. Some emerging economies have improved so much, and have risen up the credit league tables so dramatically, that they have shed the tag of emerging markets (which bears relatively higher borrowing costs) and joined the ranks of the highest-rated countries. With this, of course, comes access to the cheapest rates of borrowing. Poland and Hungary are two examples. By 2006, because both countries had made marked improvements on the economic and political fronts, they were able to issue debt of unprecedented size (both topping the €1 billion mark) at very low borrowing cost; Hungary received the cheapest-ever pricing for a central European convergence sovereign.

  Globally, developing countries are moving up credit tables. For example, the highest-quality (investment grade) share of the league table has increased from 3 to 42 per cent. And the proportion of countries remaining in the lower ranks has declined from 25 to 6 per cent. Sadly, apart from South Africa, Africa has played no part in this.

  Rebounding from a default

  Sometimes, factors are beyond a government’s control, and these can have far-reaching ramifications for the finances of even the most stable of countries. Environmental disaster (such as the 1975 frost in Brazil which devastated its coffee crop) may force a country to default on its debt obligations.

  Spain defaulted on its external debt thirteen times between 1500 and 1900. Since 1824 Venezuela has defaulted nine times. Brazil defaulted on its international debt in 1826, 1898, 1902, 1914, 1931, 1937 and 1983. Argentina defaulted in 1828, 1890, 1982, 1989 and most recently 2001.

  There are costs to defaulting, not least of which is that a country drops off the credit rating league table, and its cost of borrowing skyrockets. But, though unfortunate, defaulting is not the end of the world. The debt markets are very forgiving, and investor memory is short.

  As long as the borrower is seen to address its troubles, sometimes unforeseen, sometimes of its own making (governments have been known to be time-inconsistent – saying one thing today and doing another tomorrow – the ‘read my lips’ scenario), it can return to the market. But you can only return to the market once investors are convinced that you are politically and/or economically back on track (unfortunately, of course, aid will be given to you anyway).

  The markets have rewarded reformers. For example, just three years after it defaulted on its internal debt in 1998, the international debt markets welcomed new bond issues from Russia – the City of Moscow issued a €400 million bond in November 2001.

  And on the back of the Asia cri
sis, even though many Asian economies saw their ratings plummet and their costs of borrowing shoot up – to the point where they were effectively locked out of the capital markets until they reformed – they too were rewarded. Before the crisis, South Korea was assigned a high investment grade rating of A+ by the international rating agency Standard & Poor’s. At the height of the Asia crises in 1997, it had been downgraded nine notches to a sub-investment grade B+ rating. (It went from A+ to B+ in just two months). However, by addressing investors’ specific concerns on the need for the country to restructure its domestic banks, the country was upgraded to investment grade again in a year.

  But Africa’s defaulters have not done the same, turning away from meaningful reform, and choosing instead the deceptively easier route of aid. The typical recovery period after an emerging-market crisis has been one to two years. However, barring the Ghana and Gabon bond issues of 2007, the last time an African nation tapped the international debt markets was in the mid-1990s (Congo-Brazzaville in 1994 with a US$600 million ten-year bond issue). Of the 35-odd African countries that had issued bonds in the international capital markets around that time, virtually all of them defaulted; and in the subsequent thirty years, none of them have returned.

  They have a choice of course, but African countries have not come to the markets largely because they have not wanted to. The good news is that there are signs that this is changing. A report titled ‘Financial Institutions’ Debt Issuance is Likely to Increase in Sub-Saharan Africa’, published on 30 April 2008 on Ratings Direct, Standard & Poor’s, commented on the prospects for increasing bond issuance from Africa. The international credit rating agency noted that banks from Ghana, Kenya, and the regional monetary unions of the West African Economic and Monetary Union and the Economic and Monetary Community of Central Africa would be the most likely candidates in the next two to three years to raise long-term debt.1