Implications of rising interest costs (II)
This is the second and concluding part of the article written by the Institute for Fiscal Studies, Ghana. The first part was published in last week’s edition of the paper.
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Rising interest rates
Government borrowing to finance large budget deficits in recent years has been one of the major factors that have caused interest rates in the country to rise significantly, increasing the cost of borrowing. As borrowing increases, the government has to pay higher interest rates to the holders of its bonds.
In Ghana’s case, increased borrowings by the government have pushed up interest rates because the market fears that there is a high chance of default on the part of the government, and therefore demands higher interest rates in return for the greater risk.
Meanwhile, the higher interest rates on government bonds tend to push up other interest rates in the economy, increasing cost of credit with negative implications for investment and economic growth.
Interest rates, including the monetary policy rate, dropped sharply between 2009 and 2011 but assumed an increasing trend thereafter to reach 25 per cent in September 2015.
The average lending rate showed similar trend as the policy rate, but at a much higher rate. The 91-day rate, 182-day rate and one-year note all dropped between 2009 and 2011 but rose significantly between 2012 and 2014.
Exchange Rate Depreciation
Ghana’s public debt stock denominated in cedis has grown significantly partly as a result of the cedi depreciation over the years. Anytime the domestic currency depreciates, it affects the external debt component of the country’s debt stock by the extent of the depreciation.
An appreciation of the domestic currency has the opposite effect. Ghana’s total external public debt stood at US$2.2 billion in 2006. At the 2006 exchange rate of GH¢0.91=US$1.00, the debt counted in cedis was GH¢2.0 billion in 2006.
If the debt was not paid until September 2015 and the exchange rate remained the same, the debt would still stand at US$2.2 billion or GH¢2.0 billion. But with the cedi exchange rate depreciating to GH¢3.79=US$1.00 in September 2015, the debt stock in dollars would still be 2.2 billion but in cedi terms, it would be GH¢8.34 billion, reflecting an increase of 317 per cent in cedi terms.
The interest cost will similarly increase by 317 per cent in cedi terms between 2006 and September 2015. The difference in the increase of the external debt counted in cedis reflects the extent of the depreciation of the cedi relative to the dollar over the period.
This indicates that any time the cedi depreciates, the country’s external debt component will increase by the rate of the depreciation, commonly referred to as the “exchange valuation effect”.
The Ghanaian cedi has experienced significant volatility since its redenomination in 2007. As mentioned above, the exchange rate of the cedi increased from GH¢0.91=US$1.00 in 2006 to GH¢3.79=US$1.00 in September 2015.
After depreciating against the dollar by 23.5 per cent cumulatively from January to June 2009, the cedi strengthened from July 2009 to December 2009 when it appreciated against the dollar by 2.7 per cent cumulatively.
At end December 2010, the exchange rate of the cedi against the dollar stood at GH¢1.47=US$1.00 and by September 2011 the cedi to the dollar rate had increased to GH¢1.52. By January 2012, the rate had shot up to GH¢1.65=US$1.00 and continued to rise to GH¢1.78=US$1.00 in March 2012.
The fear was that the rate would reach GH¢2.00=US$1.00 before the end of the year if nothing was done to stem the sharp depreciation. The government undertook measures to stabilise the cedi so that by end-2012 the exchange rate had settled at GH¢1.88=US$1.00.
The cedi, however, resumed its downswing so that by end-2013, the dollar was selling at GH¢2.20.
In the beginning of 2014, the cedi lost value against the major foreign currencies, due to shortage of foreign exchange on the market, especially the US dollar. The US dollar sold at GH¢2.20 on the local foreign exchange market in December 2013 but was sold at GH¢2.60 in February 2014. This compelled the Bank of Ghana to announce new measures to salvage the downswing in the value of the cedi.
The impact of the measures was short-lived so by end-June 2014, the cedi was trading at GH¢3.00 to the dollar, significantly increasing the total public debt denominated in cedis. In the first half of 2015, the cedi depreciated rapidly again, reaching GH¢4.33=US$1.00 by end-June.
According to the government, among the factors that fueled the cedi depreciation were the outflows of foreign exchange from a higher-than-projected trade deficit resulting from the oil price decline and lower production levels of cocoa and gold.
The depreciation was also exacerbated by speculative activities on the foreign exchange market, following similar depreciation trends during the same period in 2014 (Government of Ghana, July 2015).
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Managing the public debt
To slow down interest costs to government will require a slowdown in government borrowing. The surge in government borrowing to finance the fiscal deficits was driven by a variety of factors, including the rapid growth and better economic policies pursued in the country in 2010-2012, low global interest rates, and continued economic stress in many major advanced economies, especially in Europe.
It appears that cheaper external debt than domestic debt has also been a major contributory factor behind the country’s increased borrowing from the international capital market.
Although the 2015 Budget calls for a continuation of cost-effective access to international and domestic capital markets to meet the country’s development financing needs, no strategy is introduced to manage the high and rising public debt and the associated debt-servicing burden.
The current IMF programme is also not too strong on the approach to the country’s debt management. The programme only requires the government to limit its borrowing plans to loans with a minimum grant element of 35 per cent, with possible exceptions in line with the debt limits set.
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Despite this, the fund approved for the government to issue a US$1.5 billion Eurobond in 2015. Second, with the fund programme limiting Bank of Ghana’s gross financing of the budget deficit in 2015 to only five per cent of previous year’s revenue using only marketable financial instruments, the rest of the domestic financing of the fiscal deficit will have to come from the deposit money banks and non-bank institutions through the issuance of treasury bills and bonds.
Despite this, the fiscal outlook still poses serious challenges for debt sustainability and the country is likely to continue to be at a high risk of debt distress on account of unfavourable trends in the country’s debt service relative to domestic revenues and export earnings.
This calls for additional measures and strategies to contain the rise in the public debt stock and the resulting high interest costs (see IFS, 2015).
First, government will need to adopt a debt management strategy that puts caps on the levels of gross concessional and non-concessional borrowing. Limits should also be placed on contracting and/or guaranteeing of non-concessional loans that can become liabilities to the government.
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To effectively monitor the public debt stance, strict measures and quantitative targets would have to be set to guide the efficient delivery of cash and debt management, suggesting that the plan to review and strengthen the Financial Administration Law and the accompanying Regulations is in order.
Second, as the international derivative markets have grown in sophistication, the possibilities of hedging risks associated with borrowing in foreign currencies have to be explored. Similarly, the government may consider using the interest rate swap market to manage the maturity structure of the country’s external debt.
Lowering currency risk does not preclude the country from tapping international markets to broaden its investor base, lengthen the maturity profiles or develop benchmark debt instruments.
Rather, it implies that unless the government has access to foreign currency revenues, the country’s foreign currency borrowing should, as far as possible, be hedged against currency risks to stop interest costs from rising (see IFS, 2015).
Third, as debt sustainability depends on both the costs and risks of debt service, an effective strategy must choose between domestic debt and foreign debt that strikes the optimal balance between cost and risk.
The government will have to assess whether the higher interest rate on domestic debt represents a fair compensation for insurance or a premium for the illiquidity of the domestic market or the exchange rate depreciation that could occur on the foreign currency debt, and whether such expectation is justified or reflects the lack of credibility of the monetary/exchange rate policy.
The need to ensure macroeconomic stability is also important to bring down inflation and interest rates to help ease the pressure on interest costs to the government.
Fourth, the decision of the government to deepen the domestic capital market is laudable as this will help broaden the investor base and enable the government to issue fixed-rate long-term bonds denominated in domestic currency, which will provide budget insurance against both supply and external shocks.
Conclusion
A greater access to international capital markets bestowed on Ghana and indeed many developing countries has also exposed the countries to the vicissitudes of these markets.
Already, the international capital markets’ conditions have become harsher for Ghana, both raising borrowing costs and reducing investor interest, and together with the current slowdown of economic growth, this makes it difficult for the country to service its debts without refinancing and rollovers.
The sizable external foreign currency debt of the country also makes it vulnerable to swings in international exchange rates and speculative currency attacks. Although Ghana has some flexibility in managing its borrowing on commercial terms, what is needed is to manage new debts carefully so that rollovers remain manageable.
The decision to migrate some commercially viable projects and their associated investment requirements to the Ghana Infrastructure Fund (GIF) is also a good idea as it will help reduce the government’s debt stock and the associated interest costs. References available. —Institute of Fiscal Policy, Ghana.