THE RISING PUBLIC DOMESTIC DEBT – SHOULD WE WORRY?

Shebo Nalishebo, Research FellowZambia Institute for Policy Analysis and Research

3rd April 2014

Overview

• This presentation analyses the developments in public domestic debt in Zambia and its impact on the economy for the ten-year period 2004 to 2013;

• It also provides policy recommendations on how to improve domestic debt management;

• Outline of presentation: – Fiscal framework– What constitutes domestic debt – Recent developments and trends in domestic debt– The case for domestic debt– The case against domestic debt– Implications for policy & conclusion

Summary of Fiscal Framework 2013-20142013 (K’million) % of GDP 2014 (K’million) % of GDP

Domestic revenue 24,746.0 20.4% 29,538.5 21.2%

Expenditure 32,212.2 26.6% 42,682.0 30.7%

Fiscal surplus (+)/deficit (-)

(7,466.2) (4.5%)* (13,143.5) (6.6%)

Grants 1,525.5 1.3% 2,626.6 1.9%

Borrowing 5,940.7 4.8% 10,516.9 7.5%

o/w Domestic 1,863.4 1.5% 3,501.8 2.5%

Foreign 4,077.3 3.3% 7,015.1 5.0%

*The preliminary outturn is 6.7% of GDP; Source: Ministry of Finance, 2013 and 2014 Budget Speeches

•Zambia’s 2014 fiscal framework is anchored on increasing domestic resource mobilisation and enhancing capital expenditures to finance social and economic infrastructure; •The public spending will exceed revenues by 6.6% of GDP (K13.1 billion)•Domestic borrowing has increased from 1.5% of GDP in 2012 to 2.5% of GDP in 2013

The changing face of debt, US$ millions, 2004-2013

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 -

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Total domestic debt (US$ million) Total Government external debt (US$ million)Total domestic + external debt (US$ m)

What is domestic debt?Domestic debt in Zambia is broadly defined as all central and local

government, as well as public enterprises debt contracted within Zambia

Domestic debt

Securities

Marketable: Treasury bills

& bonds

Non-marketable: megabond

Other public liabilities

Domestic arrears

Pension arrears

Awards & compensation

Distribution of domestic debt, 2013

Treasury bills; 49%

Bonds; 47%

Domestic arrears; 2% Pension arrears; 1%Awards and compensation;

1%

Recent developmentsDebt Category 2012 (K’ million) 2013 (K’ million) % change

2013/2012

Treasury bills 6,840.81 9,942.88 45.3%

Bonds 7,516.89 9,429.13 25.4%Total government securities 14,357.70 19,372.00 34.9%

Domestic arrears 483.51 486.14 0.5%

Pension arrears 66.93 125.65 87.7%Awards and compensation 164.71 250.78 52.3%

Total arrears 715.15 862.57 20.6%

TOTAL 15,072.85 20,234.57 34.2%

Source: Ministry of Finance

Government securities (ZMW million)

2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

2000

4000

6000

8000

10000

12000

Treasury bills Government bonds

Until 2013, the Government’s practice of managing domestic debt has been to issue more bonds than treasury bills

Holders of domestic debt (% shares)

2004 2005 2006 2007 2008 2009 2010 2011 2012 20130%

10%

20%

30%

40%

50%

60%

1.Banks 2. Bank of Zambia 3. Non-bank

•Commercial banks are the main players in the government securities market holding 51.5% of the total public domestic debt as at December 2013. •The treasury bills market is dominated by commercial banks, while the Government bonds market is dominated by non-banks. •Both banks and non-banks have increased their level of participation in the securities market while the central bank’s participation is on the decline.

The pros & cons of domestic debt

Pros•Current debt is sustainable•Reflects the ‘good health’ of the economy•Mitigates lending risk•Weak relationship between debt & high interest rates•Tax morality

Cons•Crowding out private sector investment•Adverse repercussions on fiscal & debt sustainability

Debt interest payments; making Government ‘lazy’; risk of short term debt

•Making banks ‘lazy’

The case for domestic debt

• The current domestic debt levels are sustainable: – Thresholds: • Debt-to-GDP: 20-25%

– Zambia’s domestic debt was 16.1% of GDP in 2013: below the sustainable threshold range

– The increase in current price GDP after benchmarking and rebasing will reduce the debt/GDP ratio for 2013 to 13.9%.

• Debt-to-revenue: 92-167%– The 2013 debt-to-revenue ratio is estimated at 82.6%,

implying that the debt is sustainable

Domestic debt-to-GDP ratios, 2004-2013

2004 2005 2006 2007 2008 2009 2010 2011 2012 20130.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Debt-to-GDP Threshold 1 Threshold 2

SUSTAINABLE

The case for domestic debt

• Reflection of the good health of the economy: – Government has been increasing its borrowing

from the domestic market without upsetting the debt sustainability thresholds

– This indicates that there are enough resources in the economy to go around

– It is a reflection of strong macroeconomic fundamentals

The case for domestic debt

• Domestic debt mitigates lending risk– Banks face a risky and unpredictable business environment, making

them reluctant to engage with the private sector, especially SMEs. – Thus, banks concentrate on providing longer term financing to

large enterprises in important strategic sectors, such as agriculture, mining and quarrying, manufacturing, and trade activities

– In providing banks with a steady and safe source of income, holdings of government securities may serve as collateral and encourage lending to riskier sectors.

– The collateral function of domestic debt may be particularly important when bank overheads cannot be reduced further, and lending risks remain high due to asymmetric information and/or weak contract enforcement.

The case for domestic debt

• Strengthening money and financial markets– Government securities are a vital instrument for the conduct of

indirect monetary policy operations and collateralised lending in interbank markets;

– Collaterised lending helps banks manage their own liquidity more effectively, reducing the need for frequent central bank interventions.

– Central banks operating in well-developed domestic debt markets do not have to rely as much on direct controls like credit ceilings, interest rate controls and high reserve requirements, all of which distort financial sector decisions and lead to financial disintermediation at the expense of private sector savings and investments

The case for domestic debt

• Weak relationship between debt and high interest rates/inflation: – It is commonly claimed that high debt-to-GDP ratio cause

macroeconomic instability resulting in high interest rates and inflation

– However, examples abound where this has not happened: • Japan’s public debt rose from below 60% in 1988 to 170% of GDP in

2007• Italy’s debt shot above 100% during the same period. • None of these countries experienced spiralling inflation or high

interest rates

– There is therefore a weak relationship between high debt-to-GDP ratio and macroeconomic instability

The case for domestic debt• Of Caesar and tax morality

– Citizens often criticise government for spending more money than it takes in– We often want mines to pay more, we demand for better roads, schools and

hospitals– But we cannot stomach the idea of decreased services or increased taxes– Are we paying our fair share of taxes?

• Landlords, are we paying property taxes? • Shoppers, do we demand VAT receipts when making purchases or we prefer

to get that ‘discount’ without a receipt and rob Government of revenue?• Consultants, are we remitting withholding tax from the consultancy fees?• How many of you who are self employed and earning more than

K3,000/month are remitting PAYE to Government? – Should we blame Government for resorting to borrowing if our tax morality is

weak?

The case against domestic debt• Crowding out private sector investment

– The crowding out of private sector investment is the most common effect touted by critics of domestic debt.

– When Government borrows domestically, it uses up domestic private savings that would otherwise have been available for private sector lending.

– In turn, the smaller residual pool of loanable funds in the market raises the cost of capital for private borrowers, reducing private investment demand, and hence capital accumulation, growth and welfare

– In a country like Zambia which has relatively shallow financial markets, with most firms being in the SME category and with limited access to international finance, domestic debt issuance can lead to both swift and severe crowding out of private lending

– This discourages private sector development, which is supposed to be the engine of growth

Domestic credit – monthly commercial banks' claims on general government & private enterprises (% of M2), 2010-2013

10-Jan

10-Mar

10-May

10-Jul

10-Sep

10-Nov

11-Jan

11-Mar

11-May

11-Jul

11-Sep

11-Nov

12-Jan

12-Mar

12-May

12-Jul

12-Sep

12-Nov

13-Jan

13-Mar

13-May

13-Jul

13-Sep

13-Nov

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Claims on general government Claims on private enterprises

Source: Bank of Zambia, Fortnightly statistics

The case against domestic debt

Adverse repercussions on fiscal and debt sustainabilitya) Debt interest payments:

– Domestic debt interest payments in 2013 amounted to K1.8 billion compared to K361 million interest payments on external debt.

– This means the interest payments on domestic debt were about four times higher than the interest payments on external debt.

– As a result, the relatively higher interest burden of domestic debt absorbed significant government revenues and thereby crowded out pro-poor and growth-enhancing spending. • The interest payments on domestic debt for 2013 are higher than the

K1.5 billion approved estimates for the Ministry of Community Development, Mother and Child Health for 2013.

The case against domestic debt

(b) Easy way out for financing Government operations: – Total revenues and grants in 2013 amounted to

K24.9 billion against the target of K26.3 billion. This means that they were below target by 5.0%.

– Faced with the constraints of collecting adequate tax revenue, Government may just resort to borrowing from the domestic market rather than enhancing their tax mobilisation efforts.

The case against domestic debt

c) Risks of short term debt– The overall debt portfolio is dominated by

treasury bills, which are short-term debt instruments,

– This makes Government vulnerable to significant defaulting risk on servicing the debt since they have to constantly roll over large amounts of debt due to unavailability of adequate funds.

– Frequent rollovers of domestic debt could also result in higher administrative costs.

The case against domestic debt

• Making banks ‘lazy’– Domestic debt instruments are generally high-yielding and

can make banks complacent about costs and reduce their drive to mobilise deposits and fund private sector projects.

– The incentive to provide credit to the private sector is often weakened by a poor credit environment.

– Hence, they weigh their risks and find that government debt is highly attractive, providing a constant flow of earnings.

– As a result, banks will have less incentive to expand credit to riskier private borrowers or cut their overheads

Implications for policy

• There is need for a domestic debt policy– The shift in the composition of overall public debt with

increasing domestic debt brings to the fore the need for Government to formulate and implement prudent domestic debt management strategies by improving oversight procedures to mitigate the effects of the rising debt levels.

– Currently, domestic debt policy is only drawn from statements such as the national budget in which the domestic borrowing threshold is one of the key macroeconomic targets, the Debt Sustainability Analysis and the Medium Term Expenditure Framework

Implications for policy

• Though attractive and sustainable, Government needs to be aware of the risks of domestic debt– The rapid growth of domestic debt reflects greater attractiveness

to the Government of issuing domestic debt. – The main risk of government debt, domestic or foreign, remains its

overall size relative to a country's fiscal and financial institutions. – While government domestic debt remains sustainable and can

mitigate lending risks and strengthens the money and financial markets, large domestic debt, like large external debt, has risks.

– Government needs to be aware of the risks and burdens in domestic debt issuance including the crowding out of small borrowers and the crowding out of pro-poor spending due to high interest payments.

Implications for policy

• There is need for a diversified investor base– Commercial banks have the largest component of

the securities market. – There is need to diversify the investor base and

create more room for non-bank financial institutions such as pensions and insurance funds to get into the Government securities market.

– A diversified investor base will help ensure high liquidity and stable demand.

Implications for policy

• There is need to develop the domestic debt market – The Government should institute policies aimed at

developing the domestic debt market to cater for more innovative instruments and facilitate secondary market trading.

– A consultation with the market players will have to be done to determine the type of instrument, maturities and interest rates which need to be introduced in the domestic debt market.

Implications for policy

• Enhance revenue mobilisation to bridge the financing gap– In order to manage the increasing domestic debt, the

Government should continue to implement measures aimed at maintaining confidence in the financial markets through prudent fiscal and monetary policy.

– With the revenue-to-GDP having reduced due to the rebasing of the GDP, the best recourse for Government is to maintain the 21% revenue-to-GDP ratio revenue collection target for 2014.

– This will require the Zambia Revenue Authority to step up their revenue collection efforts and therefore reduce the domestic borrowing target instead of incurring more debt as a result of the reduced debt-to-GDP ratio.

Should we be worried?

•The total public debt (both domestic and external) is currently in excess of US$7.2 billion. This translates to just above 30% of GDP. •Debt-to-GDP ratio of 40% is the suggested sustainable threshold for developing and emerging economies. •Our debt is well within the recommended 40% debt-to-GDP ratio•The overall budget deficit in 2013 was K7.3 billion against the target of K5.4 billion. This represented 6.7 percent of GDP above the ceiling of 4.3 percent of GDP for the year.

Should we be worried?

• Continual deficit spending sends a message of lack of fiscal discipline on the part of the government

• It also signals weak tax morality on the part of citizens• With energy and transport infrastructure having gobbled in

excess of K6 billion in 2013, spending on projects such as the five-year Link Zambia 8000 and other economic & social infrastructure, is expected to continue in the medium term.

• This implies that Government is likely to incur more debt to finance such spending, if revenue mobilisation is not improved

Should we be worried?

• The IMF warns that without a change in policies, Government debt would rise in net present value from about 30% of GDP in 2013 to over 50% by 2018, with the debt financing predominantly recurrent expenditures

• This will be above the 40% debt-to-GDP threshold for sustainability.

• Due to the foregoing, the simple answer to the question posed is “Yes, we should be worried”.

End of presentation. Thank you and God bless