On 13th November 2020, Zambia became the first African country to default on its Eurobond debt during the Covid-19 pandemic. The country missed a coupon payment of US$42.5 million, only 15 years after it had substantially reduced its external debt under the Highly Indebted Poor Countries (HIPC) initiative from a staggering US$7.1 billion in 2004 to a mere US$500 million in 2006. Our joint report by ZIPAR-FDL delves into what happened between those two dates.
The story is one of policy mistakes and bad shocks.
1. Recovery and a major shock in 2015
In 2005, Zambia reduced its significant debt, which led to five years of rapid GDP growth, sound fiscal policies, and a generally stable macroeconomic landscape. This progress resulted in the World Bank reclassifying Zambia as a lower middle-income country in 2011. In the same year, the country underwent a change in government, and the new administration initiated a large investment drive, along with expanding civil service and wages.
However, 2015 marked a turning point, with Zambia experiencing a serious drought that resulted in low precipitation and therefore impact agricultural output, particularly in the more productive southern part of the country. Due to its largely undiversified electricity sector, which is largely hydro-powered and concentrated in the drought-prone South, Zambia experienced electricity supply constraints. This led to electricity rationing by the power utility company, Zambia Electricity Supply Cooperation Limited (ZESCO), resulting in power outages of 8-12 hours per day. This adversely impacted industrial production, forcing the Zambian government to increase electricity imports and energy subsidies.
That same year, in 2015, the current account deficits widened and the Kwacha depreciated by 40 percent. This alone added 10 percentage points of GDP to the weight of external debt, denominated in dollars. Although there was an attempt to control primary deficits after 2015, the rising interest costs, as shown in figure 1, made it difficult to control overall deficits.
In 2017, the IMF and World Bank assessed that Zambia faced “high risk” of debt distress, compared to the “moderate risk” assessed two years earlier. Additionally, bonds were downgraded around the same period. The question is, what triggered this uncontrolled deterioration of interest costs? Our report thus analyses the financing conditions faced by the government.
2. An unsustainable financing strategy
Two sources helped support the increase in public spending. First, the Zambian government turned to China, a long-time bilateral partner, to finance its investment drive. This has been done through “exports and supplier’s credit”, which is a type of finance that facilitates the purchase of goods and services from the creditor country, in this case, Chinese companies. This financing source has become increasingly prominent in recent years and is now the second-largest source of total external debt (after commercial debt). Between 2011 and 2021, it has increased from US$448 million to over US$4 billion respectively, accounting for an average of 26 percent of external debt. The major clients under this category are the Exim Bank of China, which offers loans on partial concessional terms, and CATIC. In 2020, EXIM Bank of China loans totalled nearly US$3 billion, which is roughly 24 percent of total external loans.
Over the years, the government has taken out loans mainly to fund the construction and completion of infrastructure projects. These loans were not obtained on concessional terms. Figure 2 below shows the breakdown of Zambia's general government debt as a percentage of its GDP.
Zambia's financial strategy underwent a significant change in 2012 when it issued its first Eurobond worth $750 million. This was followed by two more Eurobonds in 2014 and 2015, amounting to $1 billion and $1.25 billion respectively, bringing the total to $3 billion by 2015. Shortly after, the country obtained a second and a third Eurobond in 2014 and 2015 amounting to $1 billion and $1.25 billion respectively, bringing the total to $3 billion by 2015. The interest costs on these bonds were $237 million per year (Table 1). Additonnally, the country had bank loans (including, but not limited to Chinese institutions) amounting to $2 billion, adding another $95 million in interest costs. As a result, commercial sources became the primary category of Zambia’s creditors (Figure 3).
The quality and pricing of Eurobonds have deteriorated over time, as evidenced by the rising interest rates in Table 1. The coupon rates for the 2012, 2014, and 2015 Eurobonds were 5.4%, 8.5%, and 9%, respectively. Additionally, while the first Eurobond's proceeds were fully earmarked with 60% for infrastructure, the 2014 and 2015 issuances were rather vague. In the 2014 issuance, budget support received $250 million out of a total of $1 billion. The third Eurobond was the largest, but also the vaguest, with $410 million of the total $1.25 billion not specified in the documentation. However, the Finance Minister at the time later stated in the press that it would be used for infrastructure.
3. Towards default
The result of this runaway debt was that government budgets were increasingly diverted towards debt service. By 2019, debt service became the largest spending category, accounting for more than 30% of expenditure. This surpassed economic affairs spending and represented more than three times the allocation towards education and health. During the same period, the government's reliance on domestic sources of finance, such as government bonds and treasury bills, increased.
Adding to the existing challenges, the COVID-19 shock led to a further decline in exports and revenues. This left the government with no choice but to default on its external obligations. As a result, in February 2021, Zambia formally applied to the G-20 Common Framework. This launched a long and painful process towards the country's debt restructuring, including a change in political leadership, lengthy discussions with the IMF over a country programme, and even more complex negotiations with public and private creditors, which are still ongoing.
What are the lessons of the past decade and a half? The main lesson is to exercise caution. Bonds are expensive sources of funding and require a clear and justified narrative for financial and economic returns. Lenders, both bilateral and multilateral, should also exercise more care, especially during transitions from low to middle-income economies. These transitions limit concessional finance and open the door to large flows of non-concessional finance. Under these conditions, a large exogenous shock like the one in 2015 was almost impossible to manage and led to dynamics that were difficult to control.