12 October 2022

Talking Point | Africa

UNDP rings warning bell on unfolding debt challenge

◼ Analyst commentaries and market pricing alike are flashing warning lights of an impending debt
crisis. A souring macroeconomic backdrop, comprising tightening global funding conditions and
a stronger greenback, amplifies gross financing needs and external funding requirements related
to upcoming debt maturities and current account pressures. A new paper by the UNDP
investigates the shortcomings of current debt restructuring frameworks and offers mitigating
measures which can be taken to avoid the mistakes of the past.

Entitled "Avoiding 'Too Little Too Late' on International Debt Relief", the United Nations Development
Programme's (UNDP) report, which was published on October 7, argues for "comprehensive restructuring
involving write-offs [which will allow] countries a faster return to growth, [access to] financial markets, and
development progress". Taking note of "the inertia in debt restructurings under the Common Framework for
Debt Treatments (CF)", the paper proposes "a way forward for the CF focusing on issues of official creditor
coordination, private creditor participation, and the use of state-contingent debt clauses that target future
economic and fiscal resilience". The report stresses that the focus should shift from debt rescheduling to
comprehensive restructuring as "a structurally different future" comprising tighter funding conditions and
a higher frequency of climate disasters requires "a re-think and ramp-up of official sector concessional
lending to vulnerable developing countries." Identifying 54 developing countries "with severe debt problems",
the report cautions that the largest subgroup is Sub-Saharan Africa (SSA) which, with 25 countries,
dwarfs the second-largest group (Latin America and the Caribbean with 10 countries). Together, these 54
countries represent more than 3% of global GDP and a whopping 18% of the global population.
Additionally, the countries also include 28 of the world's top-50 most climate vulnerable countries. Apart
from higher infrastructural needs to protect against the vagaries of weather, a vulnerability to climate
shocks also means that crop production (for both domestic consumption and exports) is at risk. Warning
that "an already bad debt outlook" has deteriorated further in recent months, owing to an accelerated pace
of monetary policy tightening across the globe (which tightens global funding conditions) and a decrease
in fiscal space, the UNDP argues that countries are being driven closer to debt distress.
Asserting that "the time to avert a prolonged development crisis is now", the UNDP calls upon "creditors,
debtors, and guarantors" to "act fast and decisively" to avoid a repeat of the past mistake of relief being
provided "too little too late". Part of this 'too little too late' answer to debt crises is the identification of
solvency challenges as liquidity problems. The paper states that this 'misidentification' stems partly from
"unrealistic/overoptimistic expectations about growth and fiscal balances", which, in turn, leads to an "under-
estimation of further debt build-ups and the size of write-offs needed to restore debt sustainability". Through
an assessment of forecast vintages, the UNDP warns that public debt build-up in the IMF group of
Emerging Markets and Developing Economies (EMDEs) has been underestimated over the past decade,
owing to the simultaneous under-estimation of spending and the over-estimation of revenue mobilisation.
Specifically, the forecast error boiled down to the primary balance on the fiscal account, rather than from
other debt dynamics.
Reflecting on the past, the paper argues that previous major debt crises in developing countries "were only
finally resolved" when the pursuit of debt rescheduling was abandoned in favour of debt restructuring via
face value reductions. Criticising the Brady Plan and the Highly Indebted Poor Countries (HIPC) initiatives as
"arriving late", the paper nevertheless acknowledged these programmes as significant contributors to the
reductions in debt burdens and the improvement of debt prospects at the time. However, as history has
shown, these debt relief initiatives have failed to prevent "a resurgence of debt trouble". Turning the
attention from previous debt restructuring programmes to the more recent initiative, the CF, the UNDP
asserts that "with only three countries undergoing treatment [under the CF] and none having concluded a
restructuring more than 18 months after signing on, it has not been a success". Alluding to "broad agreement

Irmgard Erasmus - Senior Financial Economist - ierasmus@oxfordeconomics.com

UNDP rings warning bell on unfolding debt challenge

that the CF needs to be reformed", the UNDP calls for additional liquidity support - in light of tightening
global financing conditions - and a "significant" step-up in official sector long-term lending.
The paper outlines that at least three prerequisites are needed to achieve an effective debt restructuring: (i)
the willingness of major creditors to work together; (ii) both debtors and creditors must commit to full
transparency, and debtors should seek restructuring earlier/pre-emptively; and (iii) restructurings should
not prioritise maturity extensions and interest rate reductions over write-offs when/if a Debt Sustainability
Analysis (DSA) suggests that write-downs are required to restore sustainability. Therefore, the UNDP
proposes that CF eligibility is expanded to cover all heavily indebted countries and calls for the
suspension of debt service payments while a debtor country is undergoing debt treatment. Drawing
from its conclusion that macroeconomic assumptions tend to err on the side of optimism, the paper also
stresses that DSAs are "grounded in realistic assumptions" regarding underlying debt dynamics including
country-specific modelling parameters, spending requirements and revenue mobilisation capacity. In this
regard, care should be given to climate change requirements. The IMF's Independent Evaluation Office
(IEO) found that debt operations with upfront fiscal adjustments and principal haircuts have been more
effective to restore debt sustainability and unlock access to conventional capital markets than a debt
rescheduling exercise which comprises reprofiling and the lowering of coupons.
It is well known that the IMF only provides financial support to countries if the debt burden is assessed to
be sustainable, or if it "believes there is a credible way to restore debt sustainability" as directed by the DSA.
The latter will partially stem from financial assurances given by major creditors and through reform
commitments made by the debtor nation's government. The UNDP paper posits that stronger emphasis is
given to the impact on low-income and vulnerable groups when debt restoration relies heavily on front-
loaded fiscal adjustments. These fiscal adjustments typically rely upon aggressive spending cuts, such as the
phasing out of broad-based subsidy programmes. The UNDP comments that "as costly and inefficient as
these programmes are, they are often the most significant social protection policy available to the poor". An
abrupt phasing-out of these supportive measures, without "readily available alternatives" aimed at
alleviating the burden on these vulnerable segments of society, will increase poverty and inequality, which
could lead to social and political unrest. Furthermore, the paper proposes the utilisation of debt-for-
development (DFD) swap agreements where creditors agree to debt write-offs in return for commitments
that the saved debt service payments will be spent on climate-related goals, such as nature conservation or
climate adaptation. The report however acknowledges that DFD swaps are "unlikely to work" as an effective
alternative to debt reorganisation for countries with an unsustainable debt load, "unless the development
conditionality is tied to a comprehensive debt restructuring akin to HIPC (where large-scale debt relief was
granted in return for prioritising poverty reduction)". Furthermore, reliance on DFD swaps may place an
asymmetrical burden of debt relief on the official sector, a challenge which the CF sought to address - the
CF championed an equitable share of the debt relief burden between creditors, citing the low share that has
historically been allocated to private creditors.
Connected to this point, the UNDP argues for incentives to invite private creditors to participate in a
debt restructuring exercise on comparable terms to other creditors through a combination of credit-
enhancements (for e.g. in the form of guarantee funds), buy-back or debt-exchange funds, and value-
recovery instruments (VRIs). A VRI incorporates the adjustment of debt payments to creditors provided that
certain economic variables (the choice to these variables relates to a debtor's debt repayment capacity)
improve beyond expectations, thereby building in an 'upside scenario' to entice private sector participation
to a debt restructuring exercise. Citing the example of the HIPC, private sector participation was
encouraged through the establishment of a buy-back fund, which provided eligible governments with grant
funding to buy back debt that trade at deep discounts. Recognising that the feasibility of buy-back funds
increases as a debtor country sinks deeper into distressed territory, the paper makes the case that "the
current environment of rapidly falling DE [developing economies] bond prices increases the relevancy and
possibility of making use of credit-enhancements and buy-back measures". VRIs, while used with "mixed
success" in the past, are also touted as a channel of incentivising private sector participation in a debt
restructuring exercise, provided that a "careful design" is in place to "avoid past mistakes". In turn, the paper
proposed the exploration of state-contingent debt instruments (SCDIs) as alternative or complement to
traditional sovereign debt instruments, as the structure of this debt instrument acts as a preventative
mechanism of debt distress. The growing frequency of climate change provides a strong basis for the

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UNDP rings warning bell on unfolding debt challenge

utilisation of SCDIs, and the UNDP comments that the current time is "a good moment" to look into the
inclusion of SCDI clauses in official debt restructuring.
We concur with the paper's central theme that "a serious debt crisis is unfolding across developing
countries, and the likelihood of a worsening outlook is high". As we mentioned in our recent webinar
and Research Briefing, we believe that African debtors will increasingly explore pre-emptive debt
restructuring prospects. This belief is underpinned by a myriad of factors, including (i) our assumption that
fragile economies will remain locked out of conventional capital markets in the lead-up to the new debt
cycle; (ii) the exploration of alternative financing options, such as green bonds, may deliver only limited
success as creditors take note of a souring macroeconomic backdrop and rising idiosyncratic risks; (iii) a
narrowing capital base will force countries to capitulate to IMF conditions, which we believe will extend to
debt restructuring exercises to restore fiscal and debt sustainability; and (iii) gross financing needs and
external financing requirements will rise owing to upcoming Eurobond maturities and persistent pressure
on the current account. We expect that global oil prices will ease from an average of $103pb this year to
$96.1pb in 2023 and $87.1pb in 2024, but geopolitical risks and supply-side factors may result in a slower
pace of price compression. In turn, weak economic growth prospects for advanced economies undermine
the demand outlook for cycle-sensitive commodity prices, which means that African countries' terms-of-
trade may deteriorate. Climate change, in particular in East Africa and Southern Africa, may undermine
harvest production owing to weak irrigation infrastructure. A climate shock will disrupt the merchandise
trade position through both suppression of export receivables and higher import requirements.
Chart 1: Fiscal position carries the weight of a high debt burden
The burden of public debt (2022-25 forecast averages)
Interest costs, % of government revenue (lhs)
Interest costs, % of GDP (lhs)
60 Government debt, % of GDP (rhs) 140

50 120

40 100

30 80

20 60

10 40

0 20
Egypt

Kenya
Angola

Ghana

Nigeria

Tunisia
Senegal

Zambia*

* Bond restructuring negotiations are still underway

Source: Oxford Economics Africa

WHY DO WE CARE? For the majority of countries covered by Oxford Economics Africa, the balance of
payments mechanism presents the primary pressure point, implying that an external debt restructuring
exercise may (i) alleviate the burden on the debt and fiscal positions, (ii) address FX imbalances (via lower
claims on the hard currency in circulation), and (iii) unlock government sources for growth-supportive
investment. However, individual risk profiles differ greatly, thereby rendering a 'one size fits all' approach
ineffective (at best) and destructive (at worst). Apart from unique trigger points, vulnerable African countries
also have different creditor structures. A wide creditor spectrum introduces greater complexity owing to private
creditors' profit focus and bankruptcy risks, and the associated greater loss aversion compared to official
creditors. Proponents for aggressive debt relief typically argue that creditors' behaviour played a role in
vulnerable countries' debt woes, specifically the exploitation of debtor nations' refinancing pressures to lock in
attractive terms at pricing (a common pitfall for countries caught in a 'debt trap'). While this may have played
a role in some cases, we believe that the majority of debt crises were borne from a combination of fiscal
spendthrift, weak governance, unrealistic budgetary projections (which underpinned borrowing targets),
exogenous shocks, insufficient policy frameworks, and socio-political factors. Unlike a post-default debt
reorganisation, negotiations on a pre-emptive external debt restructuring do not offer the debtor nation the
advantage of a captive audience. However, weaker affordability across the globe (as gauged by movements in

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UNDP rings warning bell on unfolding debt challenge

swap rates and other market pricing indicators) coupled with growing prospects for a hard landing in
advanced economies, shapes the backdrop for a prolonged loss of access to conventional debt markets for a
number of African countries. Our debt and fiscal diagnostics suggest that economies facing an upsurge in
external financing requirements (such as Ghana) could be well-positioned to negotiate a pre-emptive debt
reorganisation, and potentially seek support for a buy-back facility. Without a captive capital base, the onus
will be on fragile sovereigns to entice private sector participation in a pre-emptive debt overhaul.

Page 4 Irmgard Erasmus - ierasmus@oxfordeconomics.com