The framework for understanding the debt crisis
By Worku Aberra
December 25, 2023, marks a pivotal moment in Ethiopia’s economic history—not for Christmas celebrations, but as the anticipated day of default on its foreign debt. The Ethiopian government’s struggle to meet its financial obligations came to the forefront on December 11 when it officially informed Eurobond holders of its inability to pay the $33 million interest on its $1 billion bond issued in 2014. Despite the ongoing debt restructuring discussions with creditors since 2020, a resolution remains elusive because of differences between China and Western countries on restructuring and the reluctance of private lenders to participate in restructuring.
With the Ethiopian government already missing the interest payment deadline on December 11, it now faces a two-week grace period to make the payment by December 25. The likelihood of defaulting on the $33 million interest payment on that day is high. This imminent default is not just a concern for Ethiopia; it has consequences that will resonate throughout Africa and other developing countries. In this article, I will present a framework for understanding the underlying causes of the debt crisis for developing countries.
Before examining the causes of the debt crisis in developing countries, I would like to clarify certain terms commonly used in discussions about sovereign debt. I will define Eurobond, debt sustainability, debt structure, and debt restructuring. Despite its name, a Eurobond is not a bond denominated in Euros; it is a bond issued in a foreign currency, namely the American dollar. Sub-Saharan African countries were encouraged to issue Eurobonds beginning in the mid-2000s, with Ghana as the first country, excluding South Africa, to issue a Eurobond in 2007.
After other countries followed suit, encouraged by the IMF and the World Bank, Ethiopia issued its $1 billion Eurobond in 2014. When the Ethiopian government entered the Eurobond market, many economists predicted that it would mark the beginning of the debt trap for Ethiopia, considering both the nature of the TPLF-controlled government and the substantial amount of money borrowed.
Debt sustainability refers to a country’s ability to repay its debt without compromising its long-term economic prosperity and the well-being of its citizens. In another article, I will discuss the various indicators used to assess a country’s capacity to meet its debt obligations. Debt structure refers to the distribution of a country’s debt between short-term and long-term loans, private and public loans, commercial and non-commercial loans, as well as loans with fixed and flexible interest rates. Debt structure affects a country’s debt sustainability. Debt restructuring is the process of reducing the interest rate, decreasing the amount of debt owed, and extending the repayment period, to allow debtors to manage their debt. For restructuring to be effective, the agreement between the debtor and the creditor must provide substantial debt relief.
Assessing the debt
A debt crisis arises when a country is unable to meet its debt obligations, interest and capital, because the debt burden becomes too overwhelming for the country. The key issue is how to assess whether a country’s debt is excessively high. We can begin by examining the absolute amount of debt a country owes, but it provides an incomplete picture of the country’s level of indebtedness.
If we were to consider the absolute amount of debt owed by a country, the US stands as the most indebted country in the world today, yet it is not considered a risky borrower. Economists use several indicators to assess a country’s level of indebtedness, one of which is the country’s debt-to-GDP ratio. A high ratio suggests that the country may be at risk of meeting its debt obligations, while a low ratio implies that the country is less likely to face challenges in repaying its debt.
The debt-to-GDP ratio, however, falls short of providing a complete picture of a country’s debt repayment capacity. Many advanced countries exhibit high debt-to-GDP ratios, often exceeding 100%. For instance, according to the IMF data, Japan has a debt-to-GDP ratio that exceeds 260%, and yet it maintains a AAA credit rating. This anomaly exists because Japan can meet its debt obligations. Ethiopia’s debt-to-GDP ratio is 46.37%, lower than Kenya’s ratio of 67.94%, and notably lower than the debt-to-GDP ratio of most advanced countries.
About half of Ethiopia’s debt is external debt. According to IMF data, Ethiopia’s external debt as a percentage of its GDP is 23%, lower than Kenya’s 31.2%. Yet, despite these comparatively favorable figures, the country is on the brink of default. The problem Ethiopia faces is one of liquidity — the problem of not having sufficient foreign currency to meet its debt obligations.
Economists employ multiple indicators to gauge a country’s ability to meet its debt obligations. The debt payment to export ratio is one such indicator that illustrates a country’s potential to fulfill its financial commitments. Additionally, the debt service to revenue ratio provides insights into a country’s ability to pay its debt. Another crucial indicator is the debt service to foreign exchange reserve ratio, which reflects the amount of foreign currency a country has available to service its debt. These indicators suggest, as I will demonstrate in another article, that Ethiopia’s capacity to pay its debt is low due to a debt payment that is disproportionately high relative to the economic capabilities of the country.
Many analysts, including IMF and World Bank economists, have concluded that Ethiopia is at risk of default. The IMF, the World Bank, and the United Nations have indicated that Ethiopia’s ability to pay its debt is low, given its high scheduled debt payments.
Structural causes of the debt crisis
The debt crisis is not a new phenomenon. Throughout history, countries have grappled with debt crises when economic conditions undermined their ability to meet debt obligations. There are distinct cycles of debt crises for countries, akin to economic cycles within nations. The debt crisis cycle in developing countries originates within the international monetary and financial system when they become integrated into the system.
In the twentieth and twenty fist centuries, the debt crisis facing developing countries originated in advanced nations. As the economic situation in the advanced countries changed, the flow of capital to developing nations, including loans, fluctuated. Economic booms in industrialized nations created favorable conditions for extending loans to developing countries, while recessions and high-interest rates in advanced economies hindered the ability of developing nations to repay their debts.
The current debt crisis in developing countries, as did the debt crises of the 1970s, 1980s, and 1990s, started in advanced nations during the mid-2000s and 2010s. Excess liquidity flooded the advanced countries due to the expansionary monetary policies of central banks, including quantitative easing by the Federal Reserve Bank of the US, the European Central Bank, and others. The abundance of liquidity resulted in very low, and sometimes negative, interest rates in these nations.
The excess liquidity and low interest rates in the advanced countries encouraged commercial banks and other institutions to seek higher interest rates elsewhere, in developing countries. The pursuit of higher returns led to easy lending to African nations, including Ethiopia, in the mid-2010s by private lenders in developed countries.
As expected, when the industrial countries experienced a recession during the pandemic, it had a profound impact on the ability of developing nations to pay their debt. The combination of stimulus spending, disruptions in supply chains, and later the war in Ukraine resulted in a global inflationary situation with adverse consequences for many developing countries, especially those heavily reliant on importing food and oil.
As expected, when industrial countries experienced a recession during the pandemic, it had a profound impact on the ability of developing nations to pay their debt. The combination of stimulus spending, disruptions in supply chains, and later the war in Ukraine resulted in a global inflationary situation with adverse consequences for many developing countries, especially for those heavily reliant on importing food and oil. Their imports became more expensive, and their exports decreased, reducing substantially their foreign exchange holdings. The economic slowdown in the developed countries also reduced foreign direct investment and tourism. These effects severely handicapped the ability of the developing countries to meet debt obligations.
Furthermore, when developed countries raised interest rates to combat inflation in 2022, it had a direct negative impact on developing nations. The higher interest rates in developed countries elevated the interest rates on the short-term debt of developing nations. Capital flowed back from developing to developed countries, causing a depreciation in the values of the currencies of developing nations. The decrease in the exchange rate made imports more expensive, exacerbating the foreign exchange holdings of developing countries. Consequently, some countries, such as Sri Lanka and Lebanon, were unable to meet their debt obligations.
In short, a developing country’s debt crisis is primarily influenced by its level of integration into the international financial system, the evolving economic conditions in advanced countries, and the caliber of its policymakers—whether they are competent, dedicated, and honest. This framework serves as the foundation for comprehending the impending Ethiopian default.
Ethiopia on the brink of default
During the tenure of the TPLF-controlled government, Ethiopia, with the approval and encouragement of the IMF and the World Bank, borrowed excessively. The much-touted ‘double-digit’ economic growth was largely financed through external borrowing. Furthermore, it is evident that a portion of the borrowed funds was embezzled and illegally moved out of the country. It has been estimated that, during the TPLF’s rule, approximately $12 billion was illegally taken out of Ethiopia between 2000 and 2009 alone. Consequently, Ethiopian taxpayers are now burdened with the aftermath of these financial undertakings.
Ethiopia is grappling with significant debt obligations in the next two years. According to Fich, the country faces a payment of $1 billion in interest and principal in July 2024, another $1 billion on the Eurobond in December 2024, and an additional $2 billion in 2025. State-owned companies are obligated to pay an annual sum of $1 billion. The Abiy government has signaled its inability to cover the $33 million interest on the Eurobond and is likely to default on December 25.
The current government, under the leadership of the unstable Abiy Ahmed, has exacerbated Ethiopia’s economic problems by intentionally fostering political instability and armed conflict throughout the nation. Fitch reports that Ethiopia’s foreign exchange reserves can only cover less than one month of the country’s external payments. Consequently, Ethiopia is on the brink of defaulting on its external debt, with all the adverse short-term consequences that such a default implies. Ethiopia will join the exclusive club of defaulting countries.
Regrettably, Ethiopia finds itself on the precipice, poised to join the exclusive club of defaulting countries. The looming threat of default reflects the mismanagement of Ethiopia’s economy by the previous and current governments under the influence of the international financial system.
Worku Aberra (PhD) is a professor of economics at Dawson College, Montreal.
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