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

by Moyo, Dambisa

  The overall trend is clearly an encouraging one. Although there is still a way to go in rating governments and corporates across Africa, over the past eighteen months Standard & Poor’s has assigned long-term credit ratings to four banks in Nigeria, two of which subsequently issued debt in the international capital markets.

  It is these strides that Africa desperately needs to take. The prospect of new financial players from Africa’s banking and other private sectors bodes well for greater transparency and financial maturity, which will allow them to gain better access to both domestic and international capital markets. But, most of all, acquiring credit ratings and experience in the capital markets is the passport for Africa’s participation in the broader world architecture.

  It is incumbent on African governments to play ball. The success of the private venture into the capital markets (be they domestic or international) crucially hinges on African governments understanding the very positive economic implications of their constructive actions and grasping the opportunities the capital markets offer (better reputation, transparency, greater investment capital, longer-term reduction in borrowing costs). It also requires efficient management, and an understanding that if they are not supportive, the negative ramifications are damaging and far-reaching.

  For sure, there is an institutional imperative – it is always in the interest of international banks to lend and investors to invest – but seduced by the siren call of aid, African governments sink their ships on the rocks of development demise. The discussion thus far has focused on the international debt markets, but African countries should develop their domestic bond markets as well.

  The domestic bond markets are a prerequisite for a country’s stock market, and yet another means for the nation’s corporate sector to finance its own growth. Besides, issuing debt in the domestic markets is often cheaper than issuing debt in a foreign currency (this might explain the evolving trend in more-developed emerging countries, who have seen a shift from predominantly international debt to now roughly 70 per cent of debt in local currency). In order to pay interest and the principal on foreign debt a country has to find the foreign currency first. The risk posed by fluctuations in currencies means a borrower may have to find more of its own currency to meet the value of its foreign debt.

  There have been a number of developments towards the furtherance of these domestic markets. Take the European Investment Bank (EIB), a European financing institution established in 1958 to finance capital projects which further the European Union’s objectives (investing in small and medium-sized enterprises and in environmental-sustainability projects, for example).

  On 11 February 2008 the EIB launched its first Zambian bond denominated in the local currency. The bond transaction was for 125 billion Zambian kwacha (US$33 million) of two-year notes. Although this was not the first time the EIB had accessed the local markets in an African country – it had already done so in local currencies in Botswana, Ghana, Mauritius, Namibia and, of course, South Africa (where it has issued local-currency denominated debt for more than ten years) – it was the first time an international entity issued debt in Zambia’s local currency.

  From the EIB’s perspective, issuing debt in Zambia’s local currency just makes good business sense. It complements the EIB’s activities in Zambia as a lender in the mining industry and to small and medium-sized enterprises. Furthermore, the EIB’s currency-lending activities are aligned with their funding, which makes for good currency management.

  For Zambia, the EIB’s transaction marked the first sale of debt in an African currency to international investors, and as with the other African countries who have executed debt transactions in local currencies, the bond issue was just another way of developing and further solidifying the country’s credentials in the capital markets. It certainly helped draw the attention of international investors to the Zambian bond market. Thanks to the EIB transaction, Zambia joined a group of countries that met the criteria for issuance to the European institutional market.

  The wider debt capital markets viewed the EIB transaction as an innovative way to tap funding possibilities in relevant local currencies, the clear benefit being that the bond issue was supporting the development of local currency markets as well as taking a step towards potential future lending in local currency.

  The G8 took the decision to make local bond market development a core focus of its policy agenda. In response to this, and recognizing the importance of a private-sector role in finance in emerging economies, there has been movement in donor quarters.

  In October 2007, the World Bank (partly at the instigation of emerging-country governments) launched its Global Emerging Markets Local Currency Bond (GEMLOC) Program, designed to ‘support development of local currency bond markets and increase their investability so that more institutional investment from local and global investors can flow into local currency bond markets in developing countries’. In conjunction with private-sector participants, this is the World Bank’s first concerted foray into developing the local debt markets across emerging economies.2

  The establishment and development of local bond markets has obvious benefits to the poorest economies. Stronger, more liquid local currency bond markets can lower the cost of borrowing and reduce financing and investment mismatches and the risks they create. They support development and enhance a country’s resilience to shocks, thereby improving its financial stability.

  Yet, thus far, the development of the local debt capital markets in many of the poorest countries has been impeded by the absence of longer-term domestic bonds that are liquid (that is, can be easily bought or sold), and by a relatively weak regulatory and financial infrastructure.

  Additionally, the level at which international investors are able/willing to own locally denominated debt has been dismal; foreign institutional investors (such as pension funds and insurance companies) hold only around 10 per cent of their emerging-markets debt investments in local currency; this despite the arguments for holding local-currency denominated debt being so compelling. A portfolio which includes local emerging-market bonds offers diversification since correlations with other securities (stocks and bonds) are low, and potential returns from an improving credit environment and currency appreciation in emerging economies are attractive.

  The GEMLOC Program has three separate but complementary parts. An investment manager would be assigned to promote investment in the local-currency bonds of emerging-market countries, as well as develop investment strategies for local-currency bond markets. Shortly after the GEMLOC announcement, the bond investment organization PIMCO was selected to fulfil the role of investment manager. Next, Markit, a private-sector data and index firm, was chosen to develop a new independent and transparent bond index, for the emerging-markets local-currency debt asset class. A country’s inclusion in the new index (known as GEMX) is based on a country’s score on investability indicators, such as market size, and a set of criteria developed by the ratings, risk and research firm CRISIL. The index will open the way for a broad range of countries to be considered for investment, as currently less than 2 per cent of local-currency debt is benchmarked against leading market indices, and these include relatively few countries and instruments. The GEMX index offers an opportunity for investment strategies that include a diversified set of local emerging-market bonds with low correlations and potential returns from an improving credit environment and currency appreciation.

  Finally, the World Bank will provide advisory services to low- and middle-income countries to promote reforms aimed at developing local bond markets, improving their investability for domestic and international institutions, and enhancing financial stability. Many local markets have severe impediments on investability, such as red tape, taxes, weak infrastructure and inefficient debt management, all of which make investment in local markets unattractive.

  The idea of this leg of the GEMLOC initiative is to improve market infrastructure and regulation, and help transform em
erging local-currency bond markets into a better-known and mainstream asset class, ultimately supporting the expansion of corporate bond markets, infrastructure, and mortgage- and asset-backed financing. The hope is for involvement of the World Bank Group to cease after ten years; almost unwittingly recognizing there are other, better, private ways for emerging economies to finance their development.

  Based on the current investability criteria, only two African countries are likely to be included in the bond index – Nigeria and South Africa. Because the GEMX index will focus on countries that have local sovereign bond markets of at least US$3 billion, and sovereign bond issues of at least US$100 million (as well as at least a 50 per cent minimum score on a rank of investibility), initially it is likely that the index will only include fixed-rate government sovereign bonds from twenty countries: Brazil, Chile, China, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Nigeria, Peru, Philippines, Poland, Russia, Slovakia, South Africa, Thailand and Turkey.

  Over time, additional countries, and additional bond types (for example, company bonds), will be considered for inclusion in order to further improve liquidity. Although the stringent criteria bar many African countries from participation today, there is no reason why other African bonds should not be included over time, as their local debt markets develop. That noted, however, the high bond issuance thresholds laid out in the criteria point again to the fact that smaller African countries ought to consider more unified and integrated regional approaches to the capital markets, rather than necessarily going it alone.

  Can Dongo tap the markets?

  The capital markets are open, and open for Africa. Any assertions that these countries cannot tap the international capital markets are simply wrong. Developed countries tap the market, developing nations tap the market, even the World Bank taps the market (in a rather circular reasoning, to raise funds which they then lend on to African countries). Africa should tap the markets too. By and large, the countries that have not thus far issued bonds have not done so because they do not wish to, not because they can’t.

  The amount of emerging-market bond issuance jumped 52 per cent from US$152 billion in 2004 to US$230 billion in 2007. Currently, the total amount of bonds from government and companies in these countries stands at approximately US$1.5 trillion, of which a relatively minuscule US$10 million is from Africa. In the past ten years forty-three developing countries have issued international bonds – only three were African: South Africa, Ghana and Gabon.

  However, there are early indications that more are on the way. Since 2003, fifteen African countries have obtained credit ratings (Benin, Botswana, Burkina Faso, Cameroon, Gabon, Ghana, Kenya, Lesotho, Mali, Mauritius, Mozambique, Namibia, Nigeria, Senegal and Uganda), all of which have ratings high enough to tap the bond market. In July 2006, for instance, Zambia, Africa’s largest copper producer, announced it would seek its first credit ratings to enable it to sell bonds in international markets. The Governor of the country’s Central Bank argued that a rating would help cut Zambia’s funding costs.

  The first-order problem is whether you can tap the markets, and the second is for how much. Every year governments set up their budgets in order to determine the amount of money they will need to finance their development objectives. With this figure in mind, and assuming they appreciate the many benefits bond issuance can bring, they must embark on a roadshow. From this beauty parade – their roadshows are of course competing with other countries’ roadshows for a finite (albeit large) pool of cash – they can easily gauge how much investor appetite there is.

  As Ghana and Gabon have both demonstrated, it is perfectly possible to raise large sums. More generally, judging by the amounts realized by countries with similar ratings, the precedence has been good. For example, Turkey, rated single BB—(similar to Gabon), and Brazil, rated BBB—(as is Namibia), have raised upwards of US$1 billion in a single bond issuance. In 2006, the average bond issue by an emerging market was US$ 1.5 billion.

  As with everything, more experience yields greater rewards. As governments become more experienced and investors get to know a country better, countries can come to the markets more often (many emerging economies tap the markets every year) and in transactions of greater size.

  Some African countries might initially be viewed as too small, or too risky, to lend to. For these (Togo, Benin and Mali, for instance), and others perceived as too hazardous for individual investments, there are three risk mitigants to consider.

  One is the pooling of risk. Rather than individual countries reaching for the bond markets independently, African countries could form groups or regional coalitions, issue debt as a single entity, and divide the proceeds (and debt service obligations) accordingly. Every country would get the upside benefit of cash from the bond issue but bear the downside risk of one or many of the countries in the pool defaulting (in which case the non-defaulting countries have to repay the borrowings on behalf of the offending country or countries).

  A collective bond would undoubtedly require a unified rating (which would probably be some average of all the countries participating), but, as with the umbrella and sunscreen island example before, there are notable diversification benefits to be gained. For instance, for some countries the pooled cost of borrowing would most likely be lower than that for an individual country alone – a weighted probability of default would be lower than for an individual country’s bond issue. And much like the European Union (or any union of countries, for that matter) ‘higher-quality’ countries would be given the incentive to participate in such a structure to garner positive externalities from the neighbours’ growth as well.

  Pooling risk invariably introduces a free-rider problem; that is, the risk that one or more countries take relatively more cash out of the pot than they deserve (or add more risk to the pot than is desirable – although in this case the group of countries could simply choose to exclude the country, thereby forcing it to the markets on its own, to earn its stripes). A way around this problem would be to divide the spoils on a GDP-weighted basis – the bigger the country, the greater the share of the bond pie it receives; or on a needs basis (based on countries’ per capita income) – the greater a country’s needs, the more of the bond proceeds it would receive.

  There is another risk mitigant, which is to offer some type of insurance or payment protection in the event that a country defaults. Like any other credit guarantee, the guarantor (usually of higher credit standing than the country issuing the bond) would promise to cover some part or the full value of the bond if a country reneged on the repayment of its debt obligation.

  A recent example of this is South Africa’s Pan-African Infrastructure Development Fund (PAIDF). Launched in 2007, the PAIDF invests in infrastructure projects (transport, energy, water and sanitation, and telecommunications) across Africa, while the South African government guarantees the fund’s multi-billion-dollar investments.3 With its respectable triple B credit rating, South Africa is effectively underwriting the risk of the whole continent, and is able to provide comfort to investors, who might otherwise see the fund’s investment pool as too risky. As of October 2007, the PAIDF had raised approximately US$625 million from Africa itself (suggesting, as discussed later, that a lot of untapped cash exists on the continent).

  Another innovative example in risk mitigation is that of the Republic of Argentina, which issued a US$1.5 billion bond consisting of six bonds, guaranteed in part by the World Bank. Each bond was for US$250 million maturing at different times (one year, eighteen months, two, three, four and five years).

  The guarantee structure worked quite simply: the first bond was fully guaranteed by the World Bank. Once Argentina repaid this bond, the guarantee rolled forward to the second bond. Thereafter, it rolled to each successive bond, and so on.

  The idea of the guarantee was that if Argentina failed to repay any bond at maturity, the World Bank would immediately step in and repay it. If Argentina then repaid the World Ba
nk within sixty days of the bond’s maturity, the guarantee of the World Bank would roll to the next bond. However, if Argentina failed to repay the World Bank within sixty days (which unfortunately it eventually did), the guarantee would be lost on all the remaining bonds. Because of the World Bank’s guarantee, each of Argentina’s bonds in the series achieved a highly coveted investment grade rating based on the AAA-rated guarantee of the World Bank. Despite Argentina’s default on this structure, this is exactly the type of innovative financing structure that can help bring Africa into the global fold.

  Finally, securitizing a bond issue can also mitigate risk and reduce the cost of borrowing. The process of securitization involves ring-fencing, or setting aside, specific cashflows to pay off a debt obligation. Take an oil-producing nation as an example of how this works. The country issues debt with the understanding that all payments (interest and principal) due on the bond will be repaid by specified income earned from oil exports. Of course, there is the risk that something happens to the income stream (again, think of the Brazilian frost and the income lost on the coffee crop), but in general investors are reassured if they can see exactly how they will be repaid their investment money.

  In ‘Ending Africa’s Poverty Trap’, the economist Jeffrey Sachs et al. estimated the money needed to meet the Millennium Development Goals (MDG) (excluding government and household contributions) for Ghana, Tanzania and Uganda. They argued that this is the amount that donors would have to provide in order to finance the MDG intervention package.

  For Ghana, he estimated the total investment needs for meeting the MDG would average US$2 billion a year (or US$82.8 per year, per person). Of this total, Sachs proposed that US$1.2 billion would need to be funded by annual external assistance. Yet, although Ghana’s 2007 foray in the bond markets was only for US$750 million, it was heavily oversubscribed to the tune of US$5 billion of unmet investor demand. On the basis of Sachs’s estimate, this would have been enough to cover at least the foreseeable next five years’ MDG requirements.