Managing New Risks from Non Concessional Borrowing

1. Managing New Risks from Non Concessional Borrowing Mozambique: Economic Challenges and Opportunities Government of Mozambiquein collaboration with World Bank and IMF Christian Mulder IMF Sovereign Asset & Liability Management Division Monetary and Capital Markets Department March 22, 2010

2. Overview of presentation • Changing environment • External market borrowing • Experience of first time market issuers • Potential pitfalls, costs and risks of external borrowing • Alternative borrowing venues • Mitigating strategies • Conclusion

3. Changing environment

4. Changing environment for AFR LICs • HIPC and MDRI reduced debt • Commodity price booms improved outlook • Better structural and macro policies create resilience • Need for more borrowing • Public sector investment programs to help growth • Investments to achieve MDGs • Improved outlook puts market borrowing in reach. • In 2007, highest ever volume of bond issuance ($2.8bn) by African governments. • Challenge of maintaining debt sustainability in such a new environment

5. Concessional funding may not grow fast enough • African post-HIPC countries: Increased access to and reliance on noncessional finance for post completion countries

6. External market borrowing

7. Potential benefits of issuing internationally • Potential benefits: • Supplements domestic savings • Offsets dwindling concessional sources • Cash borrowing allows for speedier project implementation • Establishes a pricing benchmark—if there are potential domestic private issuers • But, • higher costs ….

8. Investor interest in LICs has picked up • Increase in portfolio investor interest in LICs in search of yields • LIC/EMC country risk easier to assess then “new” IC risks • Because of commodity booms better long-term prospects/lower risk • Diversification and search for “high yield” • Improved country economic policies and conditions • Likewise offers for bi-lateral loans are increasing • Countries seeking to secure commodity flows

9. EMBI Global Index: LT improvement and convergence across regions (spread over US Treasuries, percentage points)

10. Repeated periods of market closure/expensive borrowing

12. Recent experience of first-time issuers

13. Recent debut bond issues

14. A Rocky Road for new issuers • Ghana (B+) and Gabon (BB-) issued before the uptick in spreads, Senegal (B+) after • Spreads are back to issue levels • Senegal reportedly pays >+1% for small issue size • More to follow? Kenya, Tanzania ?

15. Spreads and Sovereign Ratings Cost of issue (spread) strongly depends on the sovereign credit rating Source: Bloomberg, Dealogic.

16. Factors underlying spreads at issuance • Ratings, dominated (empirically) by: • Investment/GDP • External debt/GDP or exports • Fiscal balance/debt sustainability • Reserve adequacy • Default history • Favorable country prospects more generally are relevant • Growth, inflation, current account, fiscal stance in recent years • Sustainable levels of debt • Policy transparency and adequate data dissemination • Data are now not easily accessible to the public (see Tanzania) • Data quality problems in key statistics • Supportive market environment • Successful marketing

17. Country experiences with first issues: Two opposites

18. Ghana (750 mln; 5% GDP; sep 2007) • Market pressure for augmentation (500=>750) • Elections in 2008 • Expenditure up from 2007 to 2008 by 4% of GDP; deficit up by 5%: • capital spending up only 1.3%; • wages up 1.2%; • interest cost up 0.8%; • grants down 1.4% • External debt from 17.2 % of GDP in 2006 to 29.2 % in 2008 • Current account from 9.9% of GDP in 2006 to 19.3% in 2008 • The exchange rate depreciated about 50 percent during 2008 and the first half of 2009. RER depreciated by 8% => costly (when exchange rate is overvalued like Seychelles and Argentina)

19. Gabon (1000 mln; 10% GDP; dec 2007) • Spendthrift despite Oil boom • Budget surplus from 8 % in 2007 to 12.6% in 2008 … • Gabon used its debt issuance to retire Paris Club debt • => Debt down from 44.5 % in 2007 to 22 % of GDP in 2008 • Wage expenditure flat; interest expenditure down; capital spending up • Extremely well prepared for oil price decline and non-oil, job intensive growth

20. Potential pitfalls, costs and risks

21. Typical practical pitfalls with external market borrowing (bonds or loans) • Too large issue size • Carrying cost until it can be absorbed / spent • Market pressure for augmentation • Temptation to use cash proceeds not as intended • Senegal 200 mln on GDP of 14 bln is good example • Dealing with bullet structure/repayment risk • Traditional concessional borrowing typically amortizing; bullet structure new challenge; concentrates rollover risk at one point of time • Steps to mitigate – e.g. Gabon created sinking fund (do so upfront); • Rushing to market • Unaware of cost (Latvia pulled out following road show) • Have you created enough investor awareness? Credible macro story?

22. Typical practical pitfalls • Is the use of proceeds clear? – are projects lined up; are alternatives available? Senegal good case (toll road 22 % return projection; project well vetted) • Poor choice of lead manager/syndicate • They will “sell” themselves hard. Let them work hard for you • Only focusing on fees over other services

23. What are cost pitfalls? • Overall … need to ensure apparent short-term gains does not blind to longer-term consequences / costs • E.g. developments in RER or ToT means ex-post cost much higher than anticipated (HIPC exports stagnated in eighties and nineties in nominal dollar terms) • Dutch disease (bond receipts crowd out other activity) • use external financing only for import content of projects otherwise exports are crowded out; • use complementary domestic savings for local content of projects • Cost is high compared to concessional funding, so use to supplement or to offset delays in concessional lending.

24. External borrowing also presents new risks • Refinancing riskare higher due to abrupt changes in general market conditions.. • Market discipline can be faster and harsher than official sector conditionality

25. Is it Worth it? Micro analysis critical to ensure overall Debt Sustainability • An Example • Borrow $200 million (2% of GDP) • Maturity 5 year (bullet) • Interest rate of 9% (0.18% of GDP) • what is output effect? ICOR of 4? => 0.5 % additional GDP growth. • Tax revenue 14% of GDP=> 0.14*0.5% = 0.07% of GDP more tax receipts. • Wage expenditure 8% of GDP => 0.08*0.5% = 0.04% of GDP.

26. Is it Worth it? Micro analysis critical to ensure overall Debt Sustainability • Issues • Need a source for paying interest: 5 * 0.18% of GDP. General revenue will not keep up, even if ICOR is 2.5. • Need a source to repay loan. E.g. 3 * 0.66% of GDP. If not feasible loan needs to be longer. • Sinking fund forces repayment discipline • Interest may need to be marked up to compensate early repayment into sinking fund. • eventually repayment flows to new projects and evolving borrowing. • Project soundness is critical. Needs to earn sufficient return. Need to avoid Dutch disease etc. Also will impact ICOR.

27. Is it Worth it? Micro analysis critical to ensure overall Debt Sustainability • Concrete • Toll-road in urban area (Senegal): • Cash rate of return of 22 percent: 0.4 % of GDP. Project pays itself in 5 years • Growth effect could be 1 % of GDP projected (efficiency gain double payment) • Toll road with little use (“bridge to nowhere”): • Rate of return 0 percent (revenue = maintenance cost). • Permanent growth effect 0.2 % of GDP ? • Tax gain 0.03%. Need permanent budget savings of 0.15%, and keep rolling over loan…

28. Alternative new borrowing venues

29. What are the other borrowing opportunities available? • Bilateral loans • Deeper/longer-term domestic markets.. • PPPs are potentially a significant source of financing for infrastructure. • Don’t count out multilateral aid..

30. Bilateral loans • Newer bilateral creditors are offering loans • Determining cost not always straightforward: “hidden cost” • Impact of any “tied” aid: • Benefits may be limited because of country specific inputs (how to maintain projects?) • Does it require any preferential treatment? If so, does that mean other revenues are foregone? • They can have special terms (e.g. one way bets for creditor on the exchange rate)

31. Develop domestic markets • Developing market reduces potential for “crowding out” private sector • Consider steps to encourage greater savings/facilitate financial sector deepening • E.g. greater penetration of banking (e.g. mobile phone banking), wider range of savings products • Cost is the nominal interest rate minus inflation (at the short end lower than MT foreign loans) ; what is RER trend; overvaluation? • Macro linkages are important: • A floating exchange rate regime reduces roll-over risks associated with domestic debt • Policies to support low inflation essential to develop longer term domestic markets • Is inflation indexed debt or some other protection options feasible in the mean time?

32. Exploit available aid and concessional financing • Multilateral support for infrastructure is recovering • The share of support for infrastructure in total ODA declined from 60 to 30 percent during the 1990s, but is increasing again • The share of infrastructure in total IDA credits has risen from 18 percent to 33 percent in the current decade • Sub-Saharan Africa is the largest beneficiary, with its share of IDA credits for infrastructure increasing from 38 to 62 percent of total • IDA resources for infrastructure are expected to increase

33. Mitigating strategies

34. Building institutional capacity • Traditional focus of debt manager in LICs is on recording and tracking repayment • With more choices in funding DM function needs to develop. It is beneficial to ensure • Strong institutional frameworks. Cooperation traditional project management (planning ministry/MoE) with finance side/debt office (MoF finance division). E.g. Debt Coordination Committee • Strong operational risk management frameworks: middle office function in DMO/division • Integration with DSA (debt sustainability analysis) is critical

35. Building institutional capacity • Requires different skill / mind set • More risk focused • More market aware • Financial analysis important • Debt recording still critical • Active risk management needs information on payment profiles as input in simulations • Needs high level commitment and engagement • Ministers and senior officials need to take strong ownership of process

36. Develop a Medium Term Debt Strategy... desirable more generally • MTDS defines • desired public debt composition and • a plan to achieve this composition • Objective: Meet government financing need at lowest cost consistent with a prudent degree of risk • Embedding decisions in sound MTDS framework can mitigate risk of poor choices on financing; build on DSA and build on project analysis • Ensure the right scope (include e.g. the Road Fund)

37. Develop a Medium Term Debt Strategy... desirable more generally • Fund/Bank have developed 8 step MTDS framework plus spreadsheet tool • MTDS framework forces sound assessment of • overall macro vulnerabilities • close coordination of DM with other aspects of macro policy, • supported by strong analysis of cost and risks at portfolio level • including micro details of each instrument and capacity to compare and contrast specific instruments (e.g. loans from 2 different creditors) • See e.g. Zambia, Kenya, Tanzania

38. 8-step approach Step 1 Step 2 Step 4 Step 3

39. Identify cost risk Review key trade - off for structural alternative debt factors management strategies Review Recommend implications for MTDS for macroeconomic approval policies & market 8-step approach Step 5 Step 6 Step 8 Step 7

40. Conclusions

41. Main lessons on non-concessional external borrowing: A Pragmatic View • Don’t rush and consider all options first. • Do analysis at both the macro and project level • Be wary of seemingly attractive offers by bilateral development banks • What projects return more than say 15% and yield revenue? • Mistakes can be huge • How will interest payment be generated—budget has little leeweigh • How will the loan be repaid (amortization?; high returns; or roll-over=> roll-over risk, and no truly new projects) • Where can your scarce time best be focused? • Developing domestic markets; improving aid disbursements; engaging new bilateral creditors; tapping external commercial markets ??

42. Main lessons on non-concessional external borrowing: A Pragmatic View • Move gradual, so you can learn. Do not issue more debt than needed. Pick size in line with debt strategy and plans for proceeds. • Build institutional capacity: debt management unit; DSA unit • Combine project and financial risk management expertise • Plan ahead, so as to be ready when rates are favorable • In any case (first) formulate a debt strategy • Be savvy: play investment bankers and the bi-lateral development banks after you have decided on a strategy. Do not focus on fees and rates alone • Be wary of the details: including the cost of the initial cash surplus and the cash buffers needed for repayment; the small print in bi-lateral loans • Improve your position. Prepare well for issuance (e.g. through pre-deal road-shows and good and accessible data)

43. Acknowledgements and sources • World Economic Outlook, Africa Regional Outlook (IMF) • “Strategic Considerations for First Time Sovereign Bond Issuers” (IMF WP ) • Draft Guidance Note for MTDS and MTDS spreadsheet tool • “Sovereign Issuers: Entering International Markets. A Cross Country Study”(by Blitzer)

44. THANK YOU!