Introduction
A recent Bloomberg news article(1) has hinted that the Government of Ghana is considering restructuring its sovereign debt in the wake of negotiations with the IMF regarding the sustainability of the country’s debts. The report indicated that local debt was more likely to be restructured compared to the country’s external debt. If the reports are true, a default or partial default on local currency debt first accords with what we would expect. Some scholars (see for example Gray and Malone, 2008) postulate that foreign currency debt has a higher priority compared to local currency debt. That is, foreign currency debt has a higher seniority compared to local currency debt. This is because defaulting on external debt tends to have bigger consequences. In addition, restructuring external debt may take longer, involves more creditors who have different aims and may pitch the sovereign against very powerful investors which could potentially lead to a long and drawn out legal battle. Further, restructuring external debt may have foreign relations implications. Indeed, in 1902 when Venezuela defaulted on its debt, Germany, Britain and Italy laid a siege at its ports until their debts were settled.
According to Gray and Malone, in terms of priority, a sovereign’s liabilities are usually ranked as follows (see Appendix 1);
- Guarantees to too big to fail entities which is analogous to an implicit put option
- Foreign currency debt which is conceptually analogous to risk-free debt minus an implicit put option
- Base currency money and local currency debt which are conceptually analogous to ‘equity’ and can consequently be valued as a ‘call’ option.
The Balance Sheet of Economic Agents are Inter-Linked!
A domestic debt restructuring could potentially affect households (see Appendix 2), financial institutions (see Appendix 3) and corporates (see Appendix 4) balance sheets as the balance sheets of these agents are to a large extent inter-linked.
Indeed, from Appendix 3, it is obvious that a reduction in the value of securities of financial institutions (banks, mutual funds, insurance companies, pension funds etc) will reduce their asset value, reduce their equity and increase their vulnerability and increase the implicit government financial guarantee which can create a dangerous feedback loop. That is, a debt restructuring can increase the vulnerability of the financial sector and increase the probability that the government may have to bailout the financial sector in the future, which can then worsen the government’s financial position and which can then flow back to the financial sector in a never ending cycle. Indeed, it is instructive to note that the current fiscal challenges have in part been attributed by the government to the recent financial sector clean up exercise (bailout).
Further, a weakened financial sector could impair financial intermediation leading to a hesitance of financial institutions to provide funds to individuals and businesses. This would then threaten future economic growth and development. Indeed, the present economic challenges may compromise the ability of individuals and businesses to pay their loans. This has consequential effects on banks, for example, as the liabilities of these agents form assets of financial institutions. A default from the household and corporate sector on its debt given the current economic challenges could impair the balance sheets of financial institutions which can then lead to a weakening of the sovereign balance sheet given that the value of the implicit guarantee increases as the value of bank assets drop. That is, it becomes more likely that the government would have to bailout the financial sector as the value of the financial sector’s assets drop. A debt restructuring must therefore be carefully thought through in the current economic circumstances and also given that the value of domestic debt has already been reduced in value due to inflation.
Costs and Benefits of Restructuring
We urge the Government to think carefully about a potential sovereign debt restructuring and to communicate clearly its intentions as a matter of urgency to investors and interested stakeholders. Indeed, for many months now and following the publication of the Bloomberg article, we have received numerous requests as to whether it makes sense to hold government domestic and external debt (Eurobonds). Investors are generally panicking and even individual investors in domestic instruments are considering liquidating their investments and not investing in new debt issues by the government. Consequently, it is essential that the government is transparent and engages stakeholders so that a potential non-acrimonious outcome could be achieved.
A debt restructuring entails benefits and costs. The main benefit is the reduction in debt values and an increase in the sustainability of the sovereign debt. The costs include damaging the government’s preferred credit and risk-free status, and potentially destabilizing the financial sector. Further, even though the indications are that external debt will be excluded, external creditors know that they are next in line should things get worse. Indeed, the lack of communication from the government and the uncertainty as to whether external debt will be restructured was one of the reasons given by Fitch in its recent downgrade of Ghana from ‘CCC’ to ‘CC’. Even if external debt is not restructured, Ghana is likely to be perceived to be riskier if we go ahead with a domestic debt restructuring and we may continue to pay higher risk-premiums compared to similar countries for a long-time assuming we regain access to the international bond markets in the not-too-distant future. This is because the evidence shows that once a country defaults, it is more likely to default again in the future. Once tagged as a ‘serial defaulter’, a country may experience higher interest costs, can sustain lower debts and may obtain lower maturities compared to similar countries.
In addition, a sovereign default could potentially narrow the investment options for individuals and institutions. Following the financial sector clean-up, many investors were hesitant in investing in these institutions and viewed the government as a safety net. The potential collapse of this safety net could have far-reaching and crippling ripple effects. It could push investors to seek alternatives that could lead them to losing money to charlatans given the high level of financial illiteracy in the country.
A poorly executed restructuring could potentially be more damaging to the economy in the long-term. Indeed, it could lead to capital flow reversals as foreign investors in domestic bonds flee the market and refuse to roll over their investments. Further, if depositors for example perceive that the stability of banks will be threatened, it could lead to a potentially damaging bank run. Further, the retirement security of current and future pensioners may be threatened if Pension Funds, for example, are forced to take hair-cuts. If the government calculates that the net benefits of restructuring are positive, then we provide some thoughts on what we think should be done.
What We Think Should Be Done
First of all, a borrower has the right to default. Indeed risky debt is analogous to a risk-free debt less a put option written by creditors. The borrower therefore has the right to default if the value of its assets fall below the default threshold barrier – usually the principal value of debt. Though the borrower has the right to default, unlike a normal put option, default is not a straightforward and costless process. The borrower is likely to face possible legal challenges, increased future borrowing costs, and lack of access to capital markets even if for a short period of time. Most countries who have defaulted have usually been able to regain access within a few years suggesting some ‘amnesia’ on the part of lenders.
If the government wants to proceed with a domestic debt restructuring, our recommendations in terms of ranking as follows;
- Extend maturities of debt holdings
- Reduce interest rates on debt holdings
- Haircut on principal values.
These options are the three main methods of restructuring as propounded by Buchheit Chabert, DeLong & Zettelmeyer (2018).
In terms of i), which is our preference, our suggestion is that this should not be a wholesale restructuring. As is usually the case, we expect Treasury Bills to be excluded from any potential restructuring. Further, we recommend that individual investors be exempted. We also recommend that loans of parastatal institutions such as the Ghana Cocoa Board’s Cocoa Bills should be excluded from a potential restructuring. If they are not excluded, it could set a dangerous precedent where the assets of these institutions could be attached by creditors in the event of future financial distress as they would be viewed as legitimate commercial assets of Ghana.
In terms of domestic institutional investors, we recommend that their liability structures should be considered in any restructuring. Banks generally have very short-term liabilities and consequently a potential extension of their maturities should take this into account. Non-life insurance companies typically also do not have long-time liabilities and in our opinion should be treated in a similar fashion to banks. For insurance companies (life insurance) who usually have medium-term liabilities, they can be asked to hold medium-term instruments. For mutual funds, money market mutual funds with short-term horizons should be treated differently from fixed income funds that can afford to take longer-term exposure. Pension Funds may have to carry the largest burden in terms of maturity extension. Their debt could be extended to 30 years or more.
With respect to foreign investors, depending on the size of restructuring that has to be done, we recommend that foreign holders of domestic bonds should be exempted if at all possible. This is premised on the fact that they do not benefit from the implicit financial guarantees that domestic financial institutions benefit from the government and also because of the potential of capital flow reversals. If their debt has to be restructured, then we recommend a maturity extension as well for this category of lenders.
As a final option, in addition to a maturity extension, the government can consider deferring a percentage of coupon payments. That is, the government could for example defer 40% of interest payments for both domestic and foreign investors. The amount deferred can be paid upon maturity with interest. In essence, this mimics a ‘discount’ loan such as Treasury bills but not all interest payments are deferred.
We do not think investors in general should take a haircut or a reduction in interest rates due to the potentially negative consequences. Indeed, a forced haircut could mean that financial institutions may have to be recapitalized. The big question is who will provide the funds for the recapitalization? In essence, we are calling for debt ‘reprofiling’ and not a full-blown restructuring. We believe our approach can provide the government with fiscal space whilst mitigating any negative consequences.
Though we strongly believe external debt restructuring or ‘profiling’ should be avoided, the government may take the view that we are not in 1902 and capital markets have developed more sophisticated ways of handling default since most holders of our external debt would have hedged their positions and most likely hold credit default insurance. In this case, the cost of any potential default will ultimately fall on insurance companies. However, a default will place Ghana in an uncomfortable ‘league’ as one of the few African countries to default on its Eurobonds.
Whatever approach the government adopts, it would be important for it to communicate how it intends to go about the restructuring through ‘Indicative Restructuring Scenarios’ that allows the market to better understand what the sovereign would ‘ask’ when formal negotiations begin. Further, it may be useful for the government to present the results of its stress testing showing how the proposed debt restructuring will affect the domestic financial sector and the economy in general. Further, it would need to communicate clearly what measures will be put in place to mitigate any potentially negative effects such as regulatory measures, recapitalization plans, liquidity support and setting up of a financial sector stability fund.
Finally, the government must demonstrate that it has a plan for debt sustainability in the medium to long-term to bring some stability to the economy. Otherwise, the current IMF bailout and debt restructuring may only address symptoms and we are likely to face another debt crisis in the not-too-distant future.
Written By:
Elikplimi Komla Agbloyor
Associate Professor, Department of Finance, University of Ghana Business School.
Chair of Research Committee, Tesah Capital
Data Scientist (Machine Learning and Artificial Intelligence Applications in Business)
References
Buchheit, L., Chabert, G., DeLong, C., & Zettelmeyer, J. (2018). The Sovereign Debt Restructuring Process. Sovereign Debt: A Guide for Economists and Practitioners. Washington, EE. UU.: International Monetary Fund.
Gray, D., & Malone, S. (2008). Macrofinancial risk analysis. John Wiley & Sons.
Appendix 1: Government Sector Balance Sheet
| Assets | Liabilities |
| Foreign currency reserves | Guarantees to too Big to Fail entities |
| Net fiscal assets | Foreign currency debt (Risk-free debt less a put option) |
| Other public sector assets | Base currency money and domestic currency debt (call option on public sector assets). |
Source: Gray and Malone, 2008.
Appendix 2: Household Sector Balance Sheet
| Assets | Liabilities |
| Present value of Household Income | Loans to Financial Institutions |
| Treasury Securities | Other Debt |
| Mutual Funds | Household Equity |
| Real Estate |
Source: Gray and Malone, 2008.
Appendix 3: Financial Sector Balance Sheet
| Assets | Liabilities |
| Securities including Treasury Securities | Deposits and other debt (risk-free debt minus an implicit put option) |
| Loans | Equity (implicit call option on the assets of the financial sector) |
| Government financial guarantee (analogous to a put option) |
Source: Gray and Malone, 2008.
Appendix 4: Corporate Sector Balance Sheet
| Assets | Liabilities |
| Corporate Assets | Loans to Financial Institutions |
| Other Debt | |
| Equity (implicit call option on the assets of the corporate sector) |
Source: Gray and Malone, 2008.
