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V. Local-Currency Government Debt Markets in Africa: Experiences and Policy Challenges

Author(s):
International Monetary Fund. African Dept.
Published Date:
April 2007
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Introduction

In past decades the debate on debt in Africa focused almost exclusively on external debt. More recently large-scale debt relief under the HIPC Initiative and the MDRI improved economies, and structural advances have shifted the focus to debt denominated in local currency. Although country risk is still high, low interest rates in developing and emerging markets have created incentives for foreign investors to participate in African debt markets.

This chapter examines the history and prospects of domestic government debt markets in Africa and their importance to development. Debt markets can be useful to efficient financing of a sustainable budget deficit and for building financial markets.64 While rudimentary debt markets had already emerged in the mid-1990s, after 2000 such activities accelerated substantially; more than half the countries in SSA now issue marketable domestic paper. However, because most markets are still shallow, their usefulness both in government financing and as a financial market vehicle is limited.

The chapter first discusses the links between debt markets and economic performance. It then summarizes the domestic debt situation in Africa, highlighting emerging nonbank and foreign participation, though these changes are small. The next section argues that structural obstacles in the market environment and poor, if any, debt management practices are preventing further deepening. In conclusion, the last section suggests elements of a strategy and specific measures for sustainable market growth.

Government Debt Markets and Economic Performance

For a given deficit, the way it is financed can make a difference. When foreign concessional loans are not available, many low-income countries still resort to direct borrowing from the central bank or a commercial bank. Yet the experience in emerging markets and industrial countries has shown that market-based borrowing in deep and well-functioning domestic debt markets can bring solid benefits, starting with cost-efficient financing of government debt while avoiding the monetary consequences and interest rate distortions often associated with government borrowing from central banks.

Functioning government debt markets also facilitate development of financial markets. Government debt—generally the least risky asset in an economy—provides a benchmark return for the issuance of other securitized debt, such as corporate bonds. Government debt markets are therefore a precondition for the emergence of private debt markets. They also help build interbank money markets by acting as collateral and by reducing transaction costs. Finally, because government securities are long-term investment vehicles for nonbank financial institutions like insurance companies or pension funds, they have the potential to help widen the range of institutions active in a country.

Debt markets can foster fiscal discipline and better public financial management (PFM). The need for transparency to support market-based borrowing is an incentive for governments to follow good governance, practice fiscal discipline, and enhance transparency so as to maintain and improve sovereign ratings and minimize borrowing costs. The use of market-based debt is often facilitated by the creation of a debt management office. Such an institution—which can be housed in the ministry of finance, or the central bank or be independent usually—coordinates all technical and institutional work related to financing a given fiscal deficit, and it generally has beneficial effects on research and implementation of PFM strategies.

Foreign participation comes with both benefits and risks. The benefits are an increased supply of funds, pressures for more transparent market environments (including sovereign ratings), and transfer of market expertise. Foreign money can, however, make host economies more susceptible to market volatility if it is suddenly withdrawn when investors perceive macroeconomic deterioration or contagion. Such capital market volatility has been a problem in South Africa as well as other emerging market countries.

A low level of debt, in particular if based on borrowing in the market, may also contribute to growth. Excessive government debt has clear economic costs. However, based on new research it appears that moderate levels of domestic debt can have a positive impact on growth.65 Because government debt markets promote economic efficiency and financial market depth, it seems that the link to growth is potentially stronger for securitized borrowing (Box 5.1).

Box 5.1.Is There a Link Between Domestic Debt and Growth?

The role of public domestic debt (DD)1 in economic growth in low-income countries is unclear. Because there are no suitable low-income country databases, past empirical research2 has largely been conducted on industrialized countries, where optimal debt levels were found to be 30–70 percent of GDP.3 Studies on debt and growth in low-income countries have traditionally been limited to external debt.4

Policy advice has generally cautioned low-income countries against relying to a significant extent on DD because it can threaten macroeconomic stability and crowd out private sector lending, and because of the structural obstacles to domestic borrowing, such as shallow financial markets, policies prone to financial repression, and poor debt management. Also, since most low-income countries, especially in SSA, have access to concessional loans and grants, domestic debt markets seem expensive.

More recent research emphasizes the link between domestic debt markets and growth in such areas as the collateral or safe-asset function of DD on bank balance sheets in high-risk environments, and the importance it has for deposit mobilization and private sector lending (Kumhof and Tanner, 2005); setting a benchmark yield curve for corporate bonds and longer-term bank lending to the private sector (see the recent East Asian policy initiatives on local currency bond markets); stronger institutions and domestic accountability in such areas as inflation (Abbas, 2005; Moss, Pettersson, and van de Walle, 2006); and the benefits of dependence on internal vs. external financing (Aizenman, Pinto, and Radziwill, 2004).

Two recent papers (Abbas, 2007 ; Abbas and Christensen, 2007) look at the optimal DD level in low-income countries using a new database spanning 1975-2004 and 93 developing countries (including 40 in SSA). The findings suggest that

  • Moderate levels of DD have a positive and significant impact on economic growth;
  • There is evidence of nonlinearity: debt levels above about 35 percent of bank deposits begin to undermine growth;
  • The calculus on the optimal (growth-maximizing) size of DD is sensitive to debt quality, with benefits higher for marketable debt that has positive real interest rates and is issued to the nonbank sector; and
  • Growth returns from DD are higher in riskier environments, such as in SSA. This suggests that debt markets may act as a temporary substitute for good institutions in countries just entering the reform cycle.

In many countries in SSA only recently has debt become sustainable; avoiding renewed indebtedness is a primary concern. Abbas and Christensen’s results therefore should be interpreted as underlining the importance of market-based management of debt and its rollover. The authors also emphasize the possibility of securitizing currently nonmarketable debt and sterilizing aid inflows along the yield curve, both of which would allow countries to draw the efficiency and growth benefits of establishing DD markets without compromising fiscal discipline.

Note: This box was prepared by S.M. Ali Abbas.1 Domestic debt is the sum of the claims of deposit money banks and other banking institutions on the central government and their securitized claims on the central bank.2 See, for example, Diamond (1965) on the crowding-out effects of domestic debt; Barro (1974) on debt neutrality; the EU Maastricht guidance on optimal public debt ratio; individual country debt management strategies (United Kingdom, Canada); and Aiyagari and McGrattan (1998) generally.3 Since public debt in most industrialized countries has traditionally been issued in domestic currencies to local residents, the literature on industrial country public debt can be taken as mainly addressing DD issues.4 See, for example, studies on the “secondary burden of external debt” (Rodrik, 1988); the “external debt Laffer curve” (Husain, 1997; Pattillo, Poirson, and Ricci, 2002); and “original sin” (Eichengreen and Hausmann, 2003).

Principal Characteristics and Size of Government Debt Markets in Africa

To date most debt management for African countries centered on foreign debt.66 Total public debt (foreign and domestic) in those countries increased from about 56 percent of GDP from 1975 through 1989 to nearly 100 percent from 1990 through 2004 (Abbas, 2007); concessional debt from foreign lenders accounted for the major share.

Notwithstanding the concessional elements, servicing such debt often became a drain on foreign exchange reserves, occasionally leading a country to default.67 More recently the HIPC and MDRI initiatives have, for countries with adequate macroeconomic frameworks, reduced foreign concessional debt to more sustainable levels.

A late starting point68

Domestic debt markets in Africa developed later than in most other countries. Most countries preferred to borrow extensively on concessional terms from foreign donors (in foreign currency) or from international financial institutions. In addition, countries often took loans from the domestic banking system, in many cases the government was the largest borrower from the commercial banking system. Market-based monetary policy instruments were rarely used, and the issuance of treasury bills or central bank paper was not a regular practice.

Domestic debt levels were low. Figures for total debt (nonmarketable and nonmarketable) show that outstanding stocks of domestic debt as a share of GDP were, with few exceptions, low in SSA (Table 5.1). The average domestic securitized and nonsecuritized debt-to-GDP ratio rose modestly from 11 to 15 percent over this period.

Table 5.1.Domestic Debt in Sub-Saharan Africa, 1980-2000
Percent of Total DebtPercent of GDP
1980-891990-941995-20001980-891990-941995-2000
Angola000000
Botswana000000
Burundi924326
Cape Verde0164501134
Congo, Dem. Rep. of000000
Ethiopia35169161910
Gambia, The3131831323
Ghana46122212824
Guinea
Kenya252330212322
Lesotho18158885
Madagascar522333
Malawi17871389
Mauritius415769272933
Mozambique000000
Namibia49890819
Nigeria482417282916
Rwanda32177895
São Tomé & Príncipe000000
Seychelles286575144568
Sierra Leone3072413746
South Africa100100100303745
Swaziland5457411
Tanzania2951026612
Uganda100213212
Zambia19532596
Zimbabwe574744352937
SSA282023111216
HIPC 124888611
Non-HIPC 2343340141823
Source: Christensen (2004).Note: Domestic debt includes both securitized and nonsecuritized debt.

Includes Burundi, Congo, Dem. Rep. of, Ethiopia, The Gambia, Ghana, Guinea, Madagascar, Malawi, Mozambique, Rwanda, São Tomé and Príncipe, Sierra Leone, Tanzania, and Uganda.

Includes Angola, Botswana, Cape Verde, Kenya, Lesotho, Mauritius, Namibia, Nigeria, Seychelles, South Africa, Swaziland, and Zimbabwe.

Source: Christensen (2004).Note: Domestic debt includes both securitized and nonsecuritized debt.

Includes Burundi, Congo, Dem. Rep. of, Ethiopia, The Gambia, Ghana, Guinea, Madagascar, Malawi, Mozambique, Rwanda, São Tomé and Príncipe, Sierra Leone, Tanzania, and Uganda.

Includes Angola, Botswana, Cape Verde, Kenya, Lesotho, Mauritius, Namibia, Nigeria, Seychelles, South Africa, Swaziland, and Zimbabwe.

Commercial banks were the main holders of domestic debt and secondary markets were all but absent. Given the attractiveness of the government as a borrower, domestic debt as a share of total deposits and total loans was high, above the share in other low-income countries (Gulde and others, 2006). The banking sector held on average 70 percent of outstanding debt (Figure 5.1). Central banks also held a significant share, mostly government debt acquired as banks were recapitalized. In Kenya, Mauritius, and Rwanda, the nonbank sectors, though small, did have a relatively more pronounced role. Given the shortage of other lending opportunities for commercial banks, most of them held securitized debt to maturity, and secondary market trading was low.

Figure 5.1.Holders of Domestic Debt in Selected African Countries, 2000

(Percent of total debt)

Sources: Christensen (2004)

Notes: The information on the holders of debt is for 2000, plus or minus one year. HIPC includes Burundi, Ethiopia, The Gambia, Ghana, Malawi, Rwanda, Tanzania, and Uganda. Non-HIPC includes Cape Verde, Kenya, Lesotho, Mauritius, Nigeria, Seychelles, Swaziland, and Zimbabwe.

Securitized domestic debt was often held to comply with regulations. At least seven African countries imposed liquid asset ratios (LARs) that required banks to hold a certain amount of their assets in the form of government-issued paper. It is estimated that between 1995 and 2005 about half of outstanding securitized debt was held to fulfill a LAR. While LARs have some advantages over unremunerated reserve requirements, the mandate led to distortions in the interest rate outcomes of auctions and prevented trading in secondary markets. Their use as a prudential tool for liquidity management—often the justification for imposing a LAR—is limited where there is no functioning secondary market.69

A changing landscape

Changes in the borrowing environment

A number of African countries have maintained good macroeconomic performance since the late 1990s. Improved macroeconomic management is reflected in declining rates of inflation across the continent, more sustainable fiscal frameworks, and improved current accounts. Over the past five years Africa has seen historically high growth rates, averaging 4 percent. Many countries have increased the independence of their central banks and limited or abolished direct central banks lending to governments. Improvements in other structural features—especially the legal and business environments—have been slower but such reforms are now a policy priority in many countries.

High aid inflows in a number of countries necessitated issuance of domestic debt for sterilization. Some of the accumulation of domestic debt after 2000 in SSA countries reflects sterilization of scaled-up aid after HIPC completion point and implementation of PRSPs, rather than to the financing of a budget deficit. Such sterilization has often been necessary in cases where aid inflows resulted in an expansion of domestic money supply but domestic absorption capacity was limited—for example, in Uganda and Mozambique.

Recent debt forgiveness implies renewed capacity for some African countries to issue debt. Debt relief under the HIPC Initiative, supplemented by the recent MDRI, has reduced the external debt service obligations for 16 countries in SSA. These countries have received more than US$3 billion in debt relief. In Ghana the ratio of debt service to GDP has fallen from a high of 10.8 percent in 2000 to around 1 percent.

Foreign participation

With low returns in developing and emerging market countries, the improved domestic conditions in some African countries have attracted the interest of international investors. In recent years significant liquidity has been fueled by strong economic growth globally and relative financial stability. Because the favorable conditions have driven down yields in emerging markets and industrial countries, investors have been moving to nontraditional markets like African debt markets in search of higher returns and portfolio diversification.

Though foreign participation is now a feature of debt markets in several African countries, in most countries foreigners hold only small shares of debt. Because statistics on domestic debt are often weak, in spite of ample anecdotal evidence there is only rudimentary information on the size of foreign holdings. Botswana, Ghana, Nigeria, and Zambia have seen pronounced foreign investor interest in their local currency debt markets; in Nigeria foreign subscription took up 18 percent of total marketable debt and in Zambia 16 percent at the end of 2005 (IMF, 2006, Box 2.1). Early estimates suggest that in the first half of 2006 Nigeria received portfolio inflows of roughly $1 billion, more than five times the total capital flows in 2005. Similar trends have been observed in Tanzania and Zambia.

Foreign participation is often affected by capital account and administrative restrictions. To limit the costs of volatility from any sudden stops and reversals, most countries in Africa retain controls over portfolio inflows; many do not officially allow any foreign participation. In Tanzania, for instance, while foreign investors can invest in the local stock market, they cannot buy treasury bills and bonds. In Malawi to participate in primary issuances in the local debt market foreign investors must be approved by the central bank. In some countries, though, there is evidence that foreign investors have been able to bypass such restrictions. As countries further develop their debt markets, they will need to review their stance on foreign participation (see also the section on Structural Challenges in Domestic Debt Markets).

Trends in debt levels since 200070

In most African countries fiscal performance is mostly sound, and since 2000 the overall debt-to-GDP ratio has largely held steady. Among countries for which data are available (Mellor and Guscina, 2007) only Malawi and Zambia saw significant increases of domestic debt, and that was from very low levels. Some countries, notably Ghana and Lesotho, actually saw a steep drop in domestic debt. Although the data are incomplete, it appears that maturities remain short.

The level of securitization of domestic debt differs widely from country to country (Figure 5.2). While in some all debt is securitized, most rely on a mix of nonsecuritized borrowing from commercial banks and issuance of securitized debt. However, given that the securitized but nonmarketable debt is counted, the data need to be interpreted with caution when the potential depth of secondary markets is estimated.

Figure 5.2.Securitized Debt in Selected African Countries, 2004

(Percent of total debt)

Source: Mellor and Guscina (2006).

Box 5.2.Government Securities Markets in Kenya

In Kenya, debt markets are relatively deep. Total securitized debt is 22 percent of GDP, and only a negligible portion of debt (about 3 percent) is nonsecuritized. The country has one of the most active treasury bill markets in SSA, and it has been among the few countries that have successfully lengthened maturities, which now reach up to 10 years. The central bank has also had some success in using treasury bills for open market operations and intervenes in the market to support monetary policy objectives.

Kenya’s debt markets operate in a microenvironment that is relatively supportive, but some structural features need further improvements. The debt market benefits from a healthy capital account, a managed floating exchange rate, and good settlement practices. However, there are persistent weaknesses, such as a debt management strategy that is not documented, and occasional inadequate policy coordination between the central bank and ministry of finance.

A broad base of investors is a promising feature of the market. Reflecting the wide choice of investment instruments offered, the investor base is relatively well diversified. Trusts, pension funds, and other institutional investors opt for longer maturities, which is important for asset management, development of the yield curve, and minimization of the rollover risks for the issuer. Foreign investors, though still not numerous, also tend to hold longer-term bonds (table).

Holders of Government Securities in Kenya, June 2006(percent)
Treasury

Bills
Treasury

Bonds
Total

Holdings of

Securities
Central Bank of Kenya27.40.010.2
Commercial banks36.145.942.2
Nonbank financial institutions0.40.40.4
National social security fund0.52.21.6
Parastatals and other government agencies8.18.48.3
Insurance companies8.512.110.7
Building societies0.40.80.7
Others, including foreign investors18.630.225.9
Total100100100
Source: Central Bank of Kenya, Annual Report 2006
Source: Central Bank of Kenya, Annual Report 2006

The secondary market is more active in Kenya than elsewhere in Africa except South Africa and Mauritius. Government bonds are listed on the Nairobi Stock Exchange (NSE). As the investor population diversifies, secondary trading market trading has been increasing. Between 2001 and 2003, the volume of bonds traded rose from Ksh 14 billion to Ksh 42 billion; it reached Ksh 29 billion for the first nine months of 2004. The government is looking into systems that could reduce risk in NSE deals, which might further increase trading in the secondary market.

Commercial banks are still the most important holders of public debt, but in some countries others are increasing their share. Since 2000 the share of debt held by nonbanking agents in Uganda, for instance, has gone up by 7 percentage points (Figure 5.3). In more developed markets like Botswana and South Africa, the nonbanking sector holds more than 80 percent of total debt—comparable to industrial countries.

Figure 5.3.Holders of Debt in Selected African Countries, 2001-05

(Percent of total debt)
(Percent of total debt)

Source: IMF, African Department Survey.

Note: Holdings of government debt by the banking sector include securitized debt and direct advances.

In developing domestic debt markets, crowding out of private investment needs to remain a concern. Recent research by Abbas and Christensen (2007) confirms the importance of domestic debt in commercial bank portfolios. Total securitized and nonsecuritized debt held by the government amounts on average to about one-fourth of all deposits collected, though in some cases it is significantly higher (Table 5.2).71 Similarly, in the WAEMU treasury bill market, banks holding treasury bills may have reduced lending to the private sector. While domestic debt and fiscal deficits may remain manageable, the small base of investable funds in SSA economies still means that government debt may crowd out private sector lending.

Table 5.2.Commercial Bank Holdings of Domestic Debt
Percent of GDPPercent of Total

Deposits
2004200520042005
Benin0.91.35.57.2
Botswana6.510.724.537.4
Burkina Faso1.30.69.04.5
Burundi1.53.17.715.6
Cameroon1.71.512.611.3
Cape Verde23.223.634.934.5
Central African Republic0.81.319.624.0
Chad1.10.630.219.0
Comoros0.50.48.05.4
Congo, Dem. Rep.0.60.514.511.3
Congo, Rep.1.00.313.94.8
Côte d'Ivoire3.43.322.221.6
Ethiopia8.98.319.721.4
Gambia, The9.912.529.837.3
Ghana11.611.152.750.4
Guinea4.34.144.142.0
Guinea-Bissau0.70.89.310.7
Kenya9.010.127.030.2
Lesotho5.95.027.421.1
Madagascar3.31.919.413.5
Malawi8.47.348.742.7
Mali0.61.63.28.8
Mozambique9.48.344.034.3
Namibia15.5
Niger0.60.87.88.8
Nigeria6.45.136.731.0
Rwanda1.911.0
Senegal1.81.66.76.1
Seychelles71.168.768.963.9
Sierra Leone5.45.960.857.1
Swaziland2.11.811.39.6
Tanzania2.74.115.523.1
Togo2.11.59.96.9
Uganda7.26.445.339.6
Zambia6.98.136.542.7
Zimbabwe22.863.361.9
Maximum71.168.768.963.9
Minimum0.50.33.24.5
Average6.77.126.224.6
Median3.33.321.021.2
Source: Abbas and Christensen (2007).Note: Domestic debt is the sum of the claims of deposit money banks and other banking institutions on the central government and the securitized claims of deposit money banks and other banking institutions on the central bank.
Source: Abbas and Christensen (2007).Note: Domestic debt is the sum of the claims of deposit money banks and other banking institutions on the central government and the securitized claims of deposit money banks and other banking institutions on the central bank.

Structural Challenges in Domestic Debt Markets

Despite some recent deepening, domestic debt markets in Africa are in their infancy, except in South Africa and Mauritius. Financial market environments are narrow and concentrated, and countries have limited ability to formulate and implement careful debt management.

Weak market environment

The narrow base of those investing in debt hinders market development. While auctions of government debt have in many countries been oversubscribed, the buyers are predominantly commercial banks. An example is the WAEMU area, where banks in the region bought most of the treasury bills issued since 2002. For asset management reasons banks are mostly interested in shorter-term paper, which entails higher macroeconomic (rollover) risk for the issuing government and is a disincentive for secondary market development. Because the nonbank financial sector in most African countries is negligible, both opportunity for contractual savings and demand for longer-term investment products are similarly limited. Building the relevant institutions, perhaps by a cautious shift of government pensions to a funded system, can help foster such markets, even though transition costs can be high. In Botswana, Mali, South Africa, and Uganda, for instance, the nonbanking sector now holds more than half of the government securities that have been issued.72

High real interest rates may send the wrong signals for market development, and the volatility of real returns signals high risk. Relatively closed capital markets, noncompetitive financial markets, and high credit risk contribute to high real interest rates in many African countries. A number of SSA countries have chosen to accept ratings by reputable credit rating agencies. Although many of these countries could not achieve investment-grade rating, the ratings do improve information flow.73 Still, the high rates have helped attract foreign interest, which could in the long run help make markets more efficient and better align interest costs with international rates. In the short term, though, good returns on government securities effectively crowd out other domestic investment. And taking into account inflation and exchange rate changes, the real returns for investors have been highly volatile.

Structural and other impediments hinder secondary market development. Because the supply of government bonds is often not sufficient to meet demand, many investors tend to buy and hold the securities to maturity. This is particularly true of countries with large capital inflows and funded pension plans, where demand routinely exceeds supply. Hence, even the potential for high returns in secondary market trading does not stimulate an increase in supply. In many countries, secondary markets are also hindered by considerable liquidity in the banking system, which implies that banks do not need to manage liquidity by trading in the secondary market.

Problems with issuing debt

Debt management offices could be a powerful facilitator of debt markets, but SSA still needs to put some of the preconditions in place (Box 5.3). Most debt management offices in SSA countries are housed in the central bank or the ministry of finance, where, unlike the independent offices favored in developed countries, they also have other responsibilities. Debt management officers also uniformly report a lack of resources, especially trained personnel. Debt management is also hindered by the absence of good market information and by the structures of debt markets, which, for example, do not support the long-term strategies debt managers might want to implement. Independent debt management offices could address some of these issue, but should only be put in place once a good institutional framework and proper governance procedures have been set up.

Box 5.3.Debt Management: The Essentials

Debt management is the process of issuing and managing debt. Good debt management requires a clear objective, a strategy for issuing domestic debt instruments, and an efficient institutional structure for their issuance and monitoring.

Typical objectives for issuing debt are to

  • Finance budget deficits;
  • Build markets; and
  • Implement monetary policy

The institutional framework for good debt management must be based on

  • A solid legal and regulatory system; and
  • Trading, settlement, and accounting practices that meet minimum standards, underpinned by transparency and the availability of up-to-date market information.

Debt management strategies cover the following issues:

  • Maturity structures, volumes, risk profiles, and distribution among domestic and foreign borrowing consistent with raising a given amount of debt at minimum cost to the budget;
  • Managing outstanding debt to take advantage of changing market conditions that will help continuously minimize costs.

In most SSA countries the absence of market data raises borrowing costs. Lack of information makes markets inefficient and raises the risks and, with it, the costs of doing business in African debt markets. Most debt managers in Africa are therefore convinced that improving the transparency and predictability of debt issuance is a precondition for progress and have made that a short-term goal. There are already examples of good market practices, for instance in the WAEMU region, where the central bank (the Central Bank of West African States, BCEAO) coordinates treasury bill issuance for member countries and publishes comprehensive data on outstanding amounts. Yet even for BCEAO countries and certainly for most others, regular information on country funding plans—a basic information requirement if a debt market is to be efficient—is not readily available.

In the medium and longer term, debt managers need a solid legal framework. Many countries (e.g., Nigeria) are now working to specify the legal steps and other institutional reforms needed to strengthen debt management so as to build the market. The OECD and donors are working with countries in SSA to strengthen debt management. Technical assistance is provided in the form of seminars, hands-on training for debt managers, and staff exchanges with emerging market and developed countries.

Strategies for Sustainable Market Development

Domestic government debt markets are not likely to develop until after the most pressing macroeconomic reforms are completed and the most serious structural obstacles overcome. The remainder of this chapter details reforms that may be needed to advance the fiscal agenda. These reforms and the emergence of public debt markets are also a precondition for the longer-term goal of developing corporate debt markets in Africa, which, however, may require additional steps (Box 5.4). Given the nature and extent of changes, appropriate sequencing of the reform process will also be important.

Box 5.4.Government Debt and Private Bond Market Development in Africa

The lack of long-term funds for Africa’s private sector is a major developmental obstacle. The banking sectors, the dominant financing source, can generally provide only short-term loans to reduce risk exposure. Private debt and equity markets are mostly nonexistent.

The emergence of effective corporate bond markets in Africa could be an important step in overcoming private sector financing constraints.1 Tapping domestic markets would also provide incentives for long-term savings, while avoiding possible exchange rate risk associated with issuing such bonds in international markets. Finally, local corporate bond markets would also contribute to financial sector development and support economic efficiency by making available a wider variety of longer-term investment and hedging instruments.

Experience with market development and sequencing has, however, shown that a substantial public bond market is a likely prerequisite for the emergence and growth of private debt markets because, for example,

  • Government securities act as a benchmark to establish a risk-free yield curve, and thus allow adequate pricing of corporate risk;
  • Public debt markets also help to set in place high-quality legal and technical infrastructures for debt instruments; and
  • The relatively lower risk of government debt familiarizes new investors with debt instruments.

The link between effective government bond markets and the ability of the corporate sector to issue debt is another reason to promote government borrowing in the form of local-currency bonds. However, corporate bond markets generally follow the government bond markets with a lag, which may be substantial. To help the process, countries wishing to promote corporate bond markets might consider the following steps:

  • Develop public debt markets, implementing the macroeconomic and structural reform steps outlined in this chapter;
  • Where governments run fiscal surpluses, consider issuing other types of public bonds (for example central bank bills issued for monetary policy purposes, securitization of longer-term government debt, or government-guaranteed debt issued by regional entities); and
  • Note that, in addition to well-functioning government debt markets, corporate bond markets require adequate corporate governance and transparent accounting (for investors and regulators to judge the issuing entity), and a sufficiently large group of institutional investors (e.g., insurance companies, pension funds, mutual funds); in addition, a credit rating may be required.
1 For an overview and a discussion of financing constraints, see Gulde and others (2006).

Macroeconomic reforms

Successful government debt markets rely on sound and predictable macroeconomic frameworks. Once progress on fiscal and monetary policies is consolidated there are at least three areas where further liberalization may be needed before domestic debt markets can be deepened.

  • Interest rate controls. Many African countries retain formal or informal limits on interest rates.74 Even where the rates on debt are determined by auction, interest limits on alternative investments—for example, maximum lending rates—will affect auction outcomes and may distort investor risk/return calculations.
  • Excess liquidity. In many African countries commercial banks hold unremunerated excess liquidity. Introducing a debt market without first sterilizing these funds could facilitate large government borrowing for which interest rates do not fully respond to risk differences between investment products—as the experience in some African debt markets like the WAEMU demonstrates. Even though countries in the WAEMU differ in macroeconomic performance, the regional treasury bill market initially allowed countries to issue debt at little interest rate differential.75 More recently, with lower liquidity levels, the market has started to discriminate more among borrowers.
  • Capital account. Many African countries retain formal and informal controls over investment flows. While the restrictions give these economies some protection from speculative flows and rapid reversals, they also drive a wedge between domestic and international interest rates and increase the risk premium that foreign investors demand. A review of capital regime, along with efforts to minimize distortions from controls that seem necessary in the short run, should be part of the macroeconomic strategy. Structural reforms—in particular to firm up the soundness and resilience of domestic financial sectors—should be pursued so that eventually the capital account can be liberalized.

Structural improvements

Recognizing the importance of debt markets, some countries are reviewing structural obstacles and have initiated reforms, often on securities and related laws. There have also been efforts to increase the number of sovereign ratings of African countries, which will also benefit domestic debt markets (see Box 2.3, Chapter II).

Experience in countries that already have functioning debt markets suggests that the following are critical areas:

  • Debt management strategies. Debt issuance in many African countries is handled by the ministry of finance, the central bank, or both—an arrangement with high potential for conflicts of interest and conflicting priorities. Best practices based on the experience of OECD and emerging market countries suggest that the preconditions for a dedicated office (the “debt management authority”) should be created. Once structures are sufficiently strengthened to allow such an office, it can do the necessary research to decide on an optimal debt management strategy and design maturity structures for domestic debt that are consistent with investor demands. It will also analyze the role of domestic borrowing in an optimal policy mix.76 In the interim, wherever the function is located for the transitory period, stringent transparency provisions should be put in place.
  • Market infrastructure and transparency. Unlike direct borrowing from central banks, market-based instruments require infrastructure, such as trading, settlement, and depository systems. Good practice would also require that debt be issued according to a preannounced schedule. Once auctions are completed, the results (including volumes and interest outcomes) should be promptly publicized. Predictable and timely publication of macroeconomic data will reinforce investor interest.
  • Nonbank financial institutions. Nonbank institutions are important to the collection of longer-term savings—itself a basis for debt markets. As part of its fiscal and monetary reforms, a government might consider shifting to funded pension plans, which have benefits for the development of nonbank financial sectors. The regulation of existing and emerging nonbank financial institutions clearly needs to be adapted to avoid undue risks. To the extent that institutional investors like pension funds and insurance companies are accumulating savings that can be invested in domestic debt markets, it is important that they be well regulated.

Sequencing of reforms

The reforms to support government debt markets are in most cases substantial and need to be phased in. A reform plan generally will be designed in the context of fiscal and financial sector reforms—often with technical assistance from the IMF or other donors. The appropriate sequencing of reform steps is likely to be country specific, depending crucially on initial conditions and on market size. Experience suggests the following general considerations:

  • Given implementation lags, legal and structural changes need to be initiated early in the reform process. In most countries related processes tend to be lengthy. Such changes generally not only benefit government debt market development, but financial sector development more generally or even the modernization of the business environment.
  • Macroeconomic reforms should start with the elimination of distortions that could otherwise affect the functioning of debt markets. Changes should include a move to market-based monetary policy allowing interest rates to move in response to supply and demand. Interest rate ceilings on both deposit and lending rates should be abolished with due consideration for possible portfolio effects on banks. Equally important, fiscal policy will need to be sound, to allow the shift to market-based financing without fear of excessive crowding out.
  • Because capital account liberalization is the most difficult issue, it needs to be implemented over time after supporting reforms take hold. Full capital account liberalization requires a sound and well-supervised financial sector that can withstand potentially large capital in- and outflows. Other conditions are efficient foreign exchange markets and the availability of hedging instruments to insure against capital-flow-related exchange rate risk. In the absence of these conditions countries have been advised to move gradually, liberalizing inflows before capital outflows and FDI before portfolio-related flows. Short-term capital flows should be liberalized last. However, the exact speed will need to be decided after a review of remaining restrictions and financial sector vulnerabilities. In determining the path and speed of liberalization, countries also need to recognize that the effectiveness of capital controls tends to decline over time.
Note: This chapter was prepared by Anne-Marie Gulde, Oduetse A. Motshidisi, and Smita Wagh.
64For a more general discussion on financial sector development issues see Gulde and others (2006).
65Hauner (2006) reports a similar result for financial depth. He finds that the link between government debt and financial market development is nonlinear and the effect declines with the absolute level of debt.
66The analysis in the rest of this section can—like all research on domestic debt in Africa—draw only on partial information from different surveys and may for some questions allow for only limited analysis. Data on debt exclude arrears.
67For example, Zambia and Uganda in the early 1990s.
68The analysis of the period up to 2000 draws extensively on Christensen (2004).
69This requires that the LAR be specified as an average over a period rather than a specific requirement to be met continuously.
70Data on domestic debt are hard to compile; there is as yet no comprehensive database with information for all African countries. The rest of the chapter therefore relies on surveys and other, often partial, information, which may limit comparability in the tables and charts.
71This data set excludes central bank holdings of government debt, which was included in the earlier debt statistics.
72In Botswana, central bank paper is now restricted to banks, as a monetary policy instrument; nonbanking institutions and foreigners are precluded from this market. However, nonbank investors are the largest holders of both sovereign and government-guaranteed bonds with longer maturities.
73See Box 2.3 in Chapter II for details. For a general discussion of high real interest rates, see Al-Hashimi (2007).
75Yields ranged from 2.5 to 5.5 percent.
76A related issue is the separation of the debt management function and objectives from monetary policy, although the complementarities should be recognized.

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