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Ethiopia's Eurobonds may lead to financial liberalization | Dr Costantinos Berhutesfa
Reporter: What are Eurobonds?
Costantinos: Eurobonds are a means of resource mobilization – investment finance for infrastructure development and manufacturing and help reduce budgetary deficits that have less conditionality and that may free a nation from dependence on foreign aid. The borrower has more latitude in terms of how the funds will be used; after the Highly-Indebted Poor Countries Initiative (HIPC) wiped out the debts of poor nations by the G8. Hence, the transformation in the debt burdens, capital requirements for huge infrastructure projects such as hydro dams, roads and very attractive cost of finance are driving the bond market, boosting the mushrooming bond sales. This allows countries to borrow in international financial markets where the average government debt–to-GDP ratio in Africa is below 40%).
Ethiopia has been borrowing funds for development from various sources such as the World Bank, African Development Bank, China, India and various EXIM Banks & commercial entities in the West. Each loan provided by funding nations or agencies has its own internal rationale and assessment. For instance, development bank loans such as the World Bank impart their loans at low interest rates (soft loans) or at concessionary rates. Nevertheless, Ethiopia needs to widen its loan base from available international sources for both public and private sector investment. Hence, it is imperative for a sovereign credit rating as an assessment of its credit worthiness to enable it to borrow funds. That is why Ethiopia needs to have its economy rated and hence have access to international capital markets. Based on substantial due diligence, sovereign credit assessment and evaluation is generally done by a credit rating agency such as Fitch, Standard & Poor’s or Moody’s. Ethiopia will obviously strive to have the highest possible credit rating since it has a major impact on the ability to borrow funds and the interest rates lenders charge it, because credit rating has an inverse relationship with the possibility of debt default. In the opinion of the rating agency, a high credit rating indicates that the borrower has a low probability of defaulting on the debt; conversely, a low credit rating suggests a high probability of default.
Reporter: What critical steps should be taken to prepare sovereigns for issuance of their first bond in the international market? -Experts warn debut sovereign bond issuers to keep an eye out for potential risks while diversifying their public debt profile. One is the foreign exchange risk. Can you elaborate this and how it could be relevant to Ethiopia if so?
Costantinos: This question is answered by Ethiopia’s submission on the risks of entering the international capital markets. According to Financial Times, (Javier Blas, 2014) in a write up entitled “Ethiopia issues unfamiliar investor warning over war and famine”, states ‘every country tapping the global sovereign bond market details the dangers investors face in its prospectus, often in a boilerplate section enumerating possible problems – such as fiscal deficits or taxation issues – that is largely ignored. But the document sent by Ethiopia to international investors ahead of its foray into the global sovereign bond market is somewhat different. Far from a boilerplate, it includes a list of unfamiliar hazards, such as famine, political tension and war.
The document, seen by the Financial Times, is a sobering reminder of the risk of investing in one of Africa’s less developed nations. With gross domestic product per capita at less than $550 per year, Ethiopia is the poorest country yet to issue global bonds. In the 108-page prospectus, issued ahead of its expected $1bn bond, Ethiopia tells investors they need to consider the potential resumption of the Eritrea-Ethiopia war, which ended in 2000, although it “does not anticipate future conflict”. There is also the risk of famine, the “high level of poverty” and strained public finances, as well as the possible, if unlikely, blocking of the country’s only access to the sea through neighboring Djibouti should relations between the two countries sour. Addis Ababa, Ethiopia’s capital, also warns that it is ranked close to the bottom of the UN Human Development Index – 173rd out of 187 nations – and cautions about the possibility of political turmoil. The next general election is due to take place in May 2015 and while the government expects these elections to be peaceful, there is a risk that political tension and unrest . . . may occur.”
Nevertheless, the long list of risks is not deterring investors, as ultra-low interest rates in the US, the UK, eurozone and Japan push sovereign wealth funds and pension funds into riskier countries in search of higher-yielding bonds.
Reporter: Why are sovereign bonds and the funds taped from international markets highly risky for public debt sustainability. Why is the risk higher than other forms of borrowing if so?
Costantinos: The risks are similar, as all borrowed money has to be paid back. What makes bonds more risky is the fact that some investors are focusing on the danger of a currency crisis. According to the Financial Times article, “The National Bank of Ethiopia has devalued the birr, twice over the past five years – by 23.7 per cent in 2010 and 16.5 per cent in 2011 – in an effort to win export competitiveness. Since then, the Ethiopian central bank has managed to slow the currency’s depreciation by intervening regularly in the market. Addis Ababa has now told potential investors that “it may not be possible for the National Bank of Ethiopia to manage the exchange rate as effectively in the future as it has in the past” because of reduced hard currency reserves.
The country has reserves to cover only 2.2 months’ worth of imports – almost half the 4.3 months it had in 2010-11. “Failure to manage a steadily depreciating exchange rate may adversely affect Ethiopia’s economy . . . [and its] ability to perform obligations under” the bonds, it says. The prospectus also reveals for the first time details of Ethiopia’s heavy dependence on Chinese loans to finance its infrastructure investment”.
Reporter: Most sub-Saharan African and other first time issuers went with the standard (Minimum) 500 million dollars; while almost all issued below one billion dollars. Ethiopia issued one billion dollar on its debut issue why do you think that is? Is that a safe bet to take?
Costantinos: Ethiopia has huge development projects that it requires more than a billion USD to complete. With the possibility for more FDI that comes as part of the deal with participation in international capital markets, it should be safe. This may open for the liberalization of the financial sector, which would undoubtedly ensure that Ethiopia could pay it bond purchases.
Reporter: Overall, how do you see the experience of sub-Saharan issuers and what should Ethiopia take home from their experience?
Costantinos: Fetsum Berhane, in his article, Ethiopia’s foray into Int’l capital market – lessons from Africa, submits, “Attracted by the prevailing low interest rates, cash-strapped African countries looking to borrow money on international private markets are increasingly turning to Eurobonds. In 2006, Seychelles became the first country in SSA (except South Africa), to issue bonds in 30 years time. After a year Ghana followed by raising $750 million. Since then Gabon, Senegal, Côte d’Ivoire, D.R. Congo, Nigeria, Namibia, Zambia and recently Kenya have joined them. Africa’s largest economy, Nigeria, entered the markets in 2011 with a 10-year Eurobond. In September 2012, Zambia made a splash on the international private market, launching a 10-year bond at $750 million. Rwanda followed suit in 2013 with a $400 million Eurobond. Kenya made a heavily oversubscribed inaugural debut in June to finance infrastructure projects raising $2 billion. According to Moody’s, a global credit rating agency, African countries raised about $8.1 billion in 2012. Financial Times reports investors placed orders for more than $8 billion showing the strong appetite for frontier market bonds”. Ethiopia has the no lessor objective than the other African countries.
Reporter: How do the secondary bond market operations affect the issuer country, which is sells it bonds on the primary market? How can countries use market signals in secondary bond markets where their sovereign instrument might be traded?
Costantinos: The secondary market or aftermarket is in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold or loans, which are sold by a mortgage bank to investors. It is also used to refer to the market for any used assets, or an alternative use for an existing product or asset where the customer base is the second market. For example, pepper is used as a spice in Ethiopian cuisine but a “second” or “third” market has developed for use in paint production.
With primary issuances of securities or financial instruments, or the primary market, investors purchase these securities directly from issuers such as corporations issuing shares in an IPO or private placement, or directly from the federal government in the case of treasuries. After the initial issuance, investors can purchase from other investors in the secondary market. Exchanges such as the New York Stock Exchange, London Stock Exchange and Nasdaq provide a centralized, liquid secondary market for the investors who own stocks that trade on those exchanges. Most bonds and structured products trade “over the counter,” or by phoning the bond desk of one’s broker-dealer. Loans sometimes trade online using a Loan Exchange. Nevertheless, Eurobonds purchased in primary markets will hardly end up in secondary markets for many reasons. Primarily the lack of capital and credit markets in Ethiopia will simply not avail the opportunity for such secondary markets. Secondly, the Eurobond issuers will have a say in any foray to the secondary market.
Reporter: How does international condition affect beginner bond issuers? How do the sovereign instruments of the advanced economies and monetary policy advanced nations like the US affect Ethiopia’s bond market?
Costantinos: The international condition is favorable for African Economies. While many European economies are tattering into recession, African Economies are growing rapidly. Ethiopia is one such case. Indeed the international environment is favorable to Ethiopia: in several cases, African countries have been able to sell bonds at lower interest rates than distressed European economies like Portugal, Italy, Greece and Spain. The fiscal and monetary policy of advanced economies is equally in tatters, resulting in cheep costs of capital for borrowers.
Reporter: As much as the issuance of the bonds, the spending of the funds when they materialize is also very critical. Do you advice infrastructural financing through sovereign bonds proceedings?
Costantinos: These funds can be used for a host of projects that can have short-term benefits. For example, the Gilgel Gibe III hydro dam can earn revenue of over 500 million USD annually from the sales of electricity to neighboring countries. This means that the investment of 1.6 billion USD can be technically paid up in three years. By the same token, the funds can be used to finance financial markets with a view to have faster returns and compounding effect on the use of the bonds.
Reporter: One of the requirements of issuers is to provide up to date information on the economy of country to investors. Do you think current level of economic data analysis in Ethiopia would be satisfactory to international investors? What do you advice?
Costantinos: I believe so because it is the Ethiopian government that supplies the economic statistics, besides their independent verification to credit rating agencies. Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from ‘AAA’ (excellent) and ‘AA+’ all the way to ‘C’ and ‘D’. A debt instrument with a rating below BBB- is what rating agencies consider speculative grade or a junk bond. Credit rating changes can have a significant impact on financial markets. The table here shows the sovereign debt credit rating as reported by the major credit rating agencies for Ethiopia. In general, sovereign wealth funds, pension funds and other investors to gauge the credit worthiness of Ethiopia thus having a big impact on the country’s borrowing costs use a credit rating.
Table 1. Ethiopia ratings by Standard &Poor Moody’s rating Fitch
Fitch has assigned Long-term foreign and local currency Issuer Default Ratings (IDRs) of ‘B’, Short-term foreign currency IDR of ‘B’ and a Country Ceiling of ‘B’. The Outlooks on the Long-term IDRs are STABLE. According to Fitch, the key rating drivers reflect a “balance between weak structural features indicating vulnerability to shocks and strong economic performance and improved public and external debt ratios since debt relief under HIPC in 2005-2007. More specifically, the ratings reflect the following key rating drivers: despite impressive improvement over the past decade, Ethiopia’s ratings are constrained by a weak level of development. The country ranks among the weakest Fitch-rated sovereigns on UN human development indicators, with a GDP per capita of USD500 in 2013, well below ‘B’ medians. Governance indicators as measured by the World Bank are broadly in line with ‘B’ medians. Economic performance is strong. However, the private sector’s weakness, reflecting the country’s fairly recent transition to a market economy, and its inadequate access to domestic credit, could limit growth potential over the medium-term as public investment slows
Berhane, Fetsum, Ethiopia’s foray into Int’l capital market – lessons from Africa, (Horn Affairs, October 14, 2014, http://hornaffairs.com/2014/10/14/ethiopias-foray-into-intl-capital-market-lessons-from-africa/
Blas, Javier. Ethiopia issues unfamiliar investor warning over war and famine, Financial Times 2014, http://www.ft.com/intl/cms/s/0/c8691100-7a07-11e4-8958-00144feabdc0.html?siteedition=intl#axzz3KvCb7qy0
*Source: Issuu, Dec. 2014