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The African debt dilemma: unpacking the three unfavourable factors

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Written by Carlos Lopes

Hero image description: Debt-to-GDP ratio, a large stone with text DEBT and wooden cubes with GDP letters and bag on seesaw Image credit:Debt vs GDP growth. yingko/Shutterstock.com

The debt situation in African countries has escalated to a critical juncture, as multiple factors compound the challenges they confront. Three pivotal elements significantly contribute to this predicament.

Firstly, the prudential rules governing the international banking system exacerbate the existing practices of capital concentration, amplifying the disparity in access to financial resources and hindering equitable development. Secondly, the predominant focus of multilateral institutions on poverty alleviation, while commendable, has inadvertently overlooked the pressing liquidity needs of African nations. This imbalance creates a distortion that is difficult to rectify, as it perpetuates a cycle of debt dependency rather than fostering sustainable economic growth. Thirdly, the inherent bias within credit rating agencies skews risk perceptions, unfairly penalising African countries and impeding their ability to attract investment on favourable terms.

These intertwined factors underscore the urgent need for a comprehensive understanding and proactive approach in devising effective strategies to mitigate the debt burden and pave the way for a more equitable and sustainable financial landscape across Africa.

The international banking system rules of the game

The Bank for International Settlements (BIS), often referred to as the "central bank for central banks", sets regulations and standards for the global banking system. However, these rules tend to favour developed economies, leading to unfavourable conditions for African countries. For instance, capital adequacy requirements may be disproportionately stringent for African banks, limiting their ability to lend and stimulate economic growth. Moreover, the BIS's policies often overlook the unique challenges faced by developing nations, further exacerbating their debt burden.

Following the 2008/2009 sub-prime-provoked financial crisis a set of new regulations known as Basel III were issued by the BIS. Their complexity and stringent requirements have inadvertently accelerated the withdrawal of international banks from Africa, exacerbating the region's financial challenges. The convoluted nature of these regulations, coupled with their stringent capital requirements, has made it increasingly difficult for international banks to operate profitably in African markets. As a result, many of these banks have chosen to scale back their operations or exit altogether, leaving African economies with limited access to essential financial services.

This withdrawal of international banks has significant implications for Africa's financial landscape. It reduces competition within the banking sector, limits access to credit for businesses and individuals, and hampers efforts to promote economic growth and development. Moreover, the departure of international banks undermines confidence in the region's financial markets and hinders efforts to attract foreign investment.

In a recent study by Gastón Nievas and Alice Sodano, it is revealed that the wealthiest countries have assumed the role of global bankers, attracting excess savings by offering low-yield safe assets and redirecting these funds into more profitable ventures. This privilege results in significant income transfers from the poorest to the richest nations, amounting to 1% of GDP for the top 20% of countries and 2% for the top 10%. Meanwhile, it exacerbates current account imbalances for the bottom 80% by about 2-3% of their GDP. Additionally, affluent nations experience positive capital gains, further enhancing their international investment positions. Surprisingly, this positive return differential does not stem from riskier investments but from accessing low-interest debt, both public and private, as issuers of international reserve currencies.

The limitations of Basel III regulations highlight the need for a more nuanced approach to banking regulation, particularly in emerging markets like Africa. Simplifying regulations, tailoring requirements to the specific needs of African economies, and providing support to local banks can help mitigate the negative effects of Basel III and ensure continued access to financial services for African populations. By addressing these challenges, policymakers can create a more conducive environment for sustainable economic growth and development in Africa. Counteracting entrenched privileges will require a series of policies, including tax reform, the establishment of a global reserve currency, and a restructuring of international financial institutions. These measures aim to foster a more equitable global economy, one that benefits all nations, not just the wealthiest few.

Multilateral institutions have replaced economic sense with a poverty alleviation focus

Multilateral institutions, such as the International Monetary Fund (IMF) and the World Bank, play a crucial role in providing financial assistance to African countries. However, their focus on poverty alleviation often sidelines the urgent liquidity needs of these nations. Instead of prioritising measures to address debt sustainability and promote economic stability, these institutions emphasise poverty reduction programmes, and now climate finance, which may not adequately address the root causes of the debt crisis.

During the colonial era, African economies were primarily geared towards the extraction and export of raw materials to meet the demands of colonial markets. This model entrenched a pattern of dependency on commodity exports, where the economic fortunes of many African nations became closely tied to the fluctuations of global commodity prices.

Furthermore, the legacy of colonialism fostered rentier practices, where governments relied heavily on revenue from natural resource exports rather than developing diversified domestic economies. These dynamics have contributed to the mediocre development of capital markets in many African countries. Additionally, the volatility of commodity prices has made it challenging for African nations to attract long-term investment and develop stable financial markets.

The dire situation in Africa, where access to liquidity is severely limited, exposes the harsh reality of a financial system rigged against the continent. While wealthy nations enjoy the luxury of lenient regulatory frameworks and ample fiscal space, African countries are left to fend for themselves in an environment rife with predatory lending practices and exploitative economic policies. A neoliberal agenda championed unfettered economic liberalisation and incentivised Foreign Direct Investment (FDI) through sweetheart deals, often involving tax exemptions. Consequently, capital flees Africa in search of safer destinations. This exacerbates Africa's struggle with illicit financial practices and widespread Base Erosion and Profit Shifting (BEPS) strategies employed by multinational corporations, draining its already limited resources further.

According to recent research conducted by The ONE Campaign financial transfers to developing nations have experienced a significant decline, plummeting from a peak of US$225 billion in 2014 to just US$51 billion in 2022, the latest year for which data is available. Projections indicate that these flows will further diminish by over US$100 billion in the next two years, with an estimated outflow of US$50 billion from developing countries in 2024 alone.

Alarmingly, more than one in five emerging markets and developing countries allocated a greater portion of their resources to debt servicing in 2022 than they received in external financing. Despite aid donors touting record global aid figures, nearly one in five aid dollars were directed towards domestic spending hosting migrants or supporting Ukraine, while aid to Africa has stagnated. As noted by José Antonio Ocampo, the Paris Club, the oldest debt-restructuring mechanism still in operation, exclusively addresses sovereign debt owed to its 22 members, primarily OECD countries. Africa will not be out of the doldrums with these limited attempts to address what is a major structural problem.

Significant influence of rating agencies

Rating agencies wield significant influence in the global financial landscape, shaping investor sentiment and determining borrowing costs for countries. However, their assessments are often marked by bias, particularly evident in their treatment of African countries.

Countries in Africa often derive significant income from exports, but a substantial portion of this revenue is repatriated to foreign investors, many of whom benefit from an unjust global tax system, BEPS, and illicit financial flows. Between 2000 and 2018, African countries experienced greater financial strain from profit transfers to foreign investors, dividend repatriation, and illicit financial flows than from servicing their external debt. To cover these gaps, they issued foreign-currency debt with high-interest rates, in line with Credit Rating Agencies’ assessment of their risk.

African nations argue that without bias, they should receive higher ratings, lower borrowing costs, and brighter economic prospects, as there is a positive correlation between economic development and credit ratings. However, the subjective nature of the assessment system, allegedly incorporating subjective factors, including culture or language that are unrelated to economic stability parameters, inflates the perception of investment risk in Africa beyond the actual risk of default, increasing the cost of credit. Africa’s overinflated risk perception is not even informed by a historical record of defaults.

In response, some countries have contested ratings. For instance, Zambia rejected Moody's downgrade in 2015, Namibia appealed a junk status downgrade in 2017, Nigeria contested downgrades in 2016 and 2017, Tanzania appealed against inaccurate ratings in 2018, and Ghana contested ratings by Fitch and Moody's in 2022, arguing they did not reflect the country's risk factors. Nigeria and Kenya, for example, rejected Moody's rating downgrades, citing a lack of understanding of the domestic environment by rating agencies and asserting that their fiscal situations and debt were not as dire as estimated by Moody's.

Recent arguments from the Economic Commission for Africa and the African Peer Review Mechanism (APRM) highlight deteriorating sovereign credit ratings in Africa, despite some posting growth patterns above 5% for sustained periods of time. Their joint report identifies challenges during the rating agencies’ reviews, including errors in publishing ratings and commentaries and the location of analysts outside Africa to circumvent regulatory compliance, fees, and tax obligations.

A recent UNDP report sheds light on a staggering reality: African nations stand to gain a significant boost in sovereign credit financing if credit ratings were grounded more in economic fundamentals and less in subjective assessments.

According to the report's findings, African countries could access an additional US$31 billion in new financing while saving nearly US$14.2 billion in total interest costs. Though these figures might seem modest in the eyes of large investment firms, they hold immense significance for African economies. In fact, if credit ratings accurately reflected economic realities, the 13 countries studied could unlock an extra US$45 billion in funds, a figure equivalent to the entire net Official Development Assistance (ODA) received by Sub-Saharan Africa in 2021. Furthermore, the report highlights the potential for additional funding through internationally issued Eurobonds, with African countries having the capacity to secure an extra US$15.5 billion.

Adjusting credit ratings for Eurobonds could yield savings of US$29.3 billion, emphasising the substantial impact of rating discrepancies. The stark truth revealed by these figures underscores the urgent need to address the systemic biases plaguing credit rating assessments in Africa, which have resulted in an estimated US$74.5 billion in excess interest and foregone funding—a sum considerably surpassing the entirety of Africa's net ODA assistance in 2020.

Conclusion

The ongoing discourse surrounding Africa's debt crisis often leans towards solutions centred on compensation. These proposals advocate for increased ODA, the implementation of more generous climate finance measures, or the reduction of borrowing costs through hybrid arrangements backed by international financial systems. However, as I have endeavoured to illustrate, while these measures may offer temporary relief, they fall short of constituting genuine solutions in light of the three structural challenges outlined.