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It is no longer business as usual for sovereign bond issuers

Reporter/ By Nahom Tesfaye
The recent move taken by the Government of Ethiopia to issue a sovereign bond in the international market has been seen by many as a bold decision.
Photo By: Reporter/ Nahom Tesfaye
Photo By: Reporter/ Nahom Tesfaye

Experts believe that the main reason for issuing the bond is to raise funds to finance mega projects. The absence of a vibrant financial sector in Ethiopia and fear of running down foreign exchange reserve are cited as rationales behind the move. In that regard, the government is hoping to acquire the funds to fulfill the colossal financial requirements of the Growth and Transformation Plan (GTP). Eyob Tesfaye (PhD) is a macro economist who served as head of the Public Financial Institutions Supervising Agency at the National Bank of Ethiopia. He is currently team leader, Economic Growth and Poverty Reduction at the United Nations Development Programme (UNDP). Asrat Seyoum of The Reporter sat down with Eyob at Elilly International Hotel located off Guinea Conakry Street behind UNECA to talk about the possible risks and the final results of issuing a sovereign bond in the complex international financial market. The views expressed in this interview only reflects the views of Eyob. It does not reflect the views of the UNDP or other UN agencies. Excerpts:
The Reporter: What kind of bond instruments are there in the international financial market? Can you give us some background?
Eyob Tesfaye (PhD): Bond is a debt instrument. It has a long history that dates back to the 18th century. There are two types of bonds – local bond and a bond that you use to raise funds for the international capital market. Countries usually use bonds during wartimes  and to build their economies. Many European counties were at war during that time and they used bonds to raise finances. The US also issued bonds to finance the war against Japan in the 1940s. From the economic point of view, the US used bonds to raise funds to build the huge Hoover Dam found between the state of Arizona and Nevada. With the rise of international capital flow, the local bond eventually grew to international bond markets. International bond markets proved instrumental for projects that required foreign currencies. For instance, many of Europe’s rail networks were built after raising capital using the international bond markets. Although it is a new concept for emerging economies, it has a long history in the developed world. The US bond, formerly known as Yankee bond, in particular has a long history. And since the 1970s, with the establishment of the International Monetary Fund and the World Bank, Euro bond was introduced. A Euro bond is an international bond that is denominated in a currency not native to the country where it is issued. For example, if Japan issues a bond in a currency other than the Yen, that would be a euro bond. There are various types of bonds. There is sovereign bond, which is issued by countries; corporate bond, and municipality bond, which is issued by city municipalities. There are also the so-called bullet bonds where only interests are paid and the principal is paid at the end of the maturity period. Here the interest rate is usually low but it has risks. Amortization bond is a bond where the interest and principal is paid periodically. A country with a good credit stand usually issues amortization bond. Bonds, in general, allows you to collect large sums of money. However, charging big interest rate and are prone to interest rate and exchange rate risks.
Ethiopia, last week, has issued a USD one billion sovereign bond in the international market. As a first time issuer, what critical steps should the country take?
Sovereign bond, as a debt instrument issued by a country to an international capital market, is less risky. Investors have confidence to buy the bond because it is issued by the government. The government collects tax, can raise the foreign currency reserve and control the debt. Because of these, it is perceived as less risky than other types of bonds. This being the case, many actions should be taken before and after issuing a sovereign bond. Firstly, the country has to make adjustments when it enters the international capital market. Think of the international bond market as a beauty contest. You will have to be rated before entering. You only go to the next step after passing the rating. Therefore, much like a beauty contest, the country will be assessed by credit rating agencies. There are various ratings, the lowest rating is given to those known as junk bonds. A country with a growing economy, a stable macro-economic policy, low or moderate debt and good foreign currency reserve, may join the international capital market. These measurements give you the green light to tap into the international capital market. But before issuing the bond you would need to consult financial, legal, insurance and other advisers because there are considerations such as interest rate and maturity date vis-à-vis the country’s capacity. After going through all these steps, you issue sovereign bond as it has its own risks and benefits.
How about the institutional step-ups required? Some experts suggest the establishment of a debt management institution as one of the steps. Do you see the need for such institutions for Ethiopia? 
The kind of preparation needed varies from country to country. For a nation with a satisfactory economic performance that is undertaking various infrastructure developments, some of the preparatory steps may not be needed immediately. However, a strong institutional capacity is advantageous when issuing a sovereign bond. It is not only beneficial but also necessary. Once you issue a sovereign bond and fail to pay on time, it will be very difficult to raise money from the international capital market again. Sovereign bond impacts the overall economy. It has impacts on the macro economy, debt level, foreign currency, liquidity and the finance sector. Therefore, what matters is not just that you succeeded in getting the loan but the administration of the loan also matters. Hence a debt management capacity is required. So it is not just about contracting the debt. There are considerations like what sort of foreign exchange rate, say between the USD and birr, exist? What does the international monetary policy look like? What happens if the country whose currency you used to nominate your debt revalued its currency? When this happens your debt also increases proportionally. You must always be aware of the exchange rate between the birr and USD or euro. The debt composition is also crucial. Is it better to get the loan in USD or in euro? When should it be swapped? These kinds of technical and institutional capacities are needed. Debt management could have an impact on the foreign currency. If you do not have a good debt administration capacity, if you do not know when to pay the principal or even pay the interest, it will be a problem.
Does the absence of a functioning local bond market have an impact on the issuance of the sovereign bond?
One of the main reasons why a sovereign bond is issued is the lack of adequate capital locally or the national saving being low. So you issue a sovereign bond to complement that. Secondly, when the country’s capacity to raise the supply of foreign currency is inadequate, you would tap into the international capital market to raise the foreign currency. The local bond market is limited as the country keeps on building infrastructures. Capital mobilizing capacity of the banking sector is also limited. Because the capital the country’s infrastructure demands is not commensurate with the local bond market, you issue a sovereign bond. Also, issuing a sovereign bond opens the door to spur the local bond market, brings about financial sector reform and uses a variety of debt instruments.
How do you evaluate the country’s debt management framework in terms of human capacity?
A country should base itself on the international best practice in debt management when issuing a sovereign bond. Therefore, the country should have at hand the best international practice in debt management. It needs experts well versed in exchange rate risk, interest rate risk, liquidity risk and the macro economy framework. When we talk of institutional capacity, we are not only referring to the human resource. The country needs to have a mid-term debt management framework. What should be the debt level in five years? When should it be paid? Will payment have an impact on the economy and how should it be paid? All these should be known. Not only the debt management framework but also the macro-economic framework needs a reform because when you receive a loan of 500 million dollars, it will have an impact at the macro level. It will have an impact on the inflation rate, interest rate and exchange rate. Therefore, you need a macro-economic framework that takes these things into consideration.
The risks you mentioned – liquidity, exchange rate and debt sustainability – how do you explain them in relation to directly issuing a sovereign bond?
To better understand this, we need to know the benefits of issuing a sovereign bond. First, it will have an instrumental benefit to undertake the infrastructure development projects under way or planned. It will provide complementary financing.  Secondly, issuing a sovereign bond is a testament to the international acceptance of the country’s economy. It is confidence building. Thirdly, it helps the country to attract the foreign currency available in the international capital market. Therefore, it helps the country to modernize its economy, utilize its economic potential and bring about economic transformation. So, the implication is huge for a country like Ethiopia, known for poverty and war until recently, to issue a sovereign bond and enter the international capital market. It goes beyond building infrastructures. The economy of other countries in the same basket as Ethiopia, is likened to a street child. The fact that they are now issuing a sovereign bond indicates that they are no longer playing in the peripheries. This helps to boost investment and integrate in the global economy. But it has its own huge risks. It is important where you use the loan. For instance, the government of Greece were issuing sovereign bonds to raise salaries every election year to extend its stay in power. Instead of raising productivity and building its economy the government was subsidizing. Soon enough, the economy collapsed and Greece turned into a banana republic. Therefore, where you would use the loan is very important. The other is a carry-on risk. If you do not start the projects on time or if there is a delay, the interest would keep accumulating. Your debt will pile up and your capacity to return the loan will be shaken. For example, if you use the loan to build a sugar factory but if the project is not finished in time to export the sugar and earn a foreign currency to repay the loan, the carry-on cost will be too heavy. Therefore, it is important to minimize carry-on costs. When you talk about exchange rate risk, there are two scenarios. For instance, if there is a huge supply of USD in the country and when it is not properly administered, the purchasing power of the birr will be stronger against the USD and that would create an over-valuation of the currency. Over-valuation will impact the export earning. The other scenario is the country’s foreign currency earning capacity to offset the loan. A country which issues a sovereign bond will have to double its foreign currency earnings. With regard to interest rate risk, as opposed to a fixed interest rate if the sovereign bond is issued with a flexible interest rate, then a changing interest rate will pose a risk. So, there are overall macro-economic risks including debt sustainability. If the economy is not strong enough to shoulder debts, then it will affect the debt sustainability. Plus if the amount of loan is too much, it will create a credit boom which will have an inflationary effect. Then you would have to control inflation with monetary and fiscal policies. The macro-economic framework of a country which entered the international capital market by issuing a sovereign bond will no longer be business as usual. The macro-economic activity will be scrutinized by the creditors. So, it is of paramount importance to have a strong, improved and prudential macro-economic management.
Staying on debt sustainability, the country has been receiving commercial and concessional loans until now. What are the risks that are peculiar to issuing sovereign bond with regard to debt sustainability?  
Unlike recent trends, African countries were not issuing sovereign bonds because their economies were not attractive enough and there were no creditors. Due to infrastructure developments, African countries have started issuing sovereign bonds in recent times. Some of them have been receiving concessional loans, particularly from China. When these concessional loans begin to dry up, they turned their attention to sovereign bonds. I am not sure about Ethiopia’s specific factor. The country is still receiving concessional loans. The debt management situation is less risky. That is why the country has issued a sovereign bond worth one billion USD. A country in the high risk category would find it difficult to subscribe a sovereign bond worth that much. The debt sustainability issue goes from low risk to moderate and then to high risk. It is largely preferred if it stays moderate. Otherwise, if it reaches the high risk category, the debt will be unsustainable. In the 1990s, the debt of many countries was unsustainable. One of the sovereign bonds what is known as bread bond, was issued to address the debt sustainability problem. So, you can use a sovereign bond not only to build infrastructures but also to minimize your debt. For example, if you have a short-term loan, you issue a long-term sovereign bond to serve the short-term debt.
Most sub-Sahara African countries and other fist time issuers went with the standard (minimum) 500 million USD Ethiopia, issuing a one billion USD on its début issue, may be like you said taking into account the country’s debt stress level. Would you think that would change the country’s external debt condition from where it is now?
Years back, the minimum amount for first time issuers of a sovereign debt used to be 50 million USD. Eventually, it grew to 500 million USD. Countries that issue a sovereign bond worth 500 million USD consider a number of factors. Like I said, sovereign bond would help to build infrastructure, foster economic transformation and some would use it as a test case before joining the international capital market, something like a benchmarking debt. For instance, Nigeria issued 500 million USD as a benchmark debt. Zambia issued 750 million USD. What is most important is why you need the loan; what should be the size of the loan. The biggest determining factor in all this is the country’s debt stress level. Ethiopia’s external debt in proportion to the GDP currently stands at 47%. This is one of the lowest in the world. The majority of Ethiopia’s loans are concessional. Commercial loans are very rare. As long as the country keeps its debt sustainability rate to a minimum or moderate level and maintains its capacity to repay the loan, then issuing a sovereign bond will not be a problem. So the main issue is not joining the international capital market to raise the loan, but how you utilize that loan.
Much of sovereign bonds issued by sub-Sahara African countries are aimed at financing infrastructure projects. Ethiopia’s sovereign bond is issued with a maturity date of ten years. Assuming the debt will be used to finance infrastructure projects, do you think the maturity date is too short?    
As we said, the size of the sovereign bond is very important. A person cannot carry five quintals if his maximum capacity is two quintals. So, I assume the loan servicing capacity of the country is taken into account when issued. The other is foreign exchange generation capacity. In fact, infrastructure development projects take longer time to complete. However, you do not wait for a single infrastructure project to be completed to generate foreign currency. You would have to explore other options to generate foreign currency. In addition, you would have to attract more foreign direct investment into the country. You would have to transform the economy. When you transform and liberalize your economy, your loan servicing capacity will also increase. Without economic transformation, the infrastructure project alone may not be able to service the loan. Therefore, sectoral transformation is required. It is important to have transformation within the agriculture sector and transformation from agriculture-led to industrialization to expand your options of foreign currency generation. Then, there would be no need to wait for a single infrastructure project to be completed to service the loan.
Now that the country has entered the international capital market, I’m interested to know how the international market dynamics affect the domestic market. We read reports that these issues of sovereign bonds by sub-Sahara countries are due to an expected revision of its interest rates by the US treasury.
There are actually two main factors behind the recent issuance of sovereign bonds by African countries. The first is an improved economic activity with a stable macro-economy and political stability. The debt level is not to the level it was in the 1980s and 90s. So, now they have reached a level where they can issue a sovereign bond. It is the first for many of these African countries. Many of them used to rely on concessional loans. But, when you look at it from a different perspective, actors in the international capital market who extend loans to African countries have their own reasons. African countries including Angola, Cote d’Ivoire, Ghana, Gambia, Nigeria, Tanzania, Namibia, Zambia and recently Ethiopia have issued bonds worth 11 billion in total. From the point of view of creditors, due to the sluggish performance of the global economy particularly in Europe, the interest rate they get is down to zero. So, instead of sitting with their money, they started to lend to African countries after calculating the risk. Therefore, we need to look at it from both perspectives. There is an attractive economic situation in Africa and a zero interest rate elsewhere. Creditors in the international capital market are also testing Africa’s economy. Before fully immersing themselves, they are testing the depth of the water with one foot inside.
One of the requirements of issuers is to provide up-to-date information on the economy of the country of investors. Do you think current level of economic data analysis in Ethiopia would be satisfactory to international investors? What do you advice?
Participating in the international capital market in itself would help improve the standard of the country’s economy, helps to raise complementary finance and attracts foreign direct investment. However, there will also be responsibilities that come along with it. As I said earlier, the macroeconomic management can no longer be business as usual. There is a disclosure standard. You would have to harmonize your economic data. Not only that, you would also have to be transparent. When there is a request for any relevant macro-economic data, you are required to provide it. You cannot choose and pick which to disclose and which not. Your debt management system has to be up to international standard. That includes disclosure. Therefore, accounting, auditing and financial sector standards would have to improve. So, if there are challenges, I would view them from their positive aspects of entering the international capital market. If you improve the loan servicing capacity, budgetary discipline, monetary policy and so on, then joining the international capital market is a blessing. Without these reforms, entering the market is risky.
From the experience of some of the sub-Sahara African countries mentioned earlier, what lessons can Ethiopia as a new comer draw? 
There are lessons. For example, the Latin America debt crisis was, firstly, a result of lack of a prudential debt management system. Secondly, they did not use the loan to finance the productive sector. Thirdly, the open capital account and capital mobility prior to the issuance of the bond led to the flow of capital out of the country. And fourthly, there is failure to improve the foreign currency earning capacity. When you come to African countries, it is a very recent phenomenon. In this regard, we can draw lessons from the experience of Seychelles and Ghana. The problem in Seychelles was their foreign currency generation capacity whereas the macro-economic management was an issue in Ghana. Following the devaluation of Ghana’s currency by some 30 percent, the country’s loan, whose interest rate was originally 8.75 percent practically grew to some 12.75 percent. Therefore, it is important to take into account your loan servicing capacity, improve your foreign currency earning and fiscal deficit. All these should be synchronized in a coordinated manner and for that institutional capacity has to improve. Your creditors do not wish to fall in the abyss staring at the beauty contestant. They closely follow your macro-economic management. So, you need to build a strong and prudential macroeconomic strategy and a mid-term debt strategy.
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