A government which decides to borrow – either because it has programmed a budget deficit or needs to refinance maturing debts – faces two, non-mutually exclusive possibilities: borrow domestically in the local currency or borrow externally in a foreign currency.
Developed countries borrow predominantly at home and in their currencies. This is because they have deep domestic financial markets. Developing countries are different. Their governments are more likely to supplement domestic borrowing with debt from abroad in foreign currencies.
There are a few options when borrowing from abroad: from other countries (bilateral), from multilateral institutions like the International Monetary Fund, World Bank and the African Development Bank, or from the international capital markets.
Ghana taps both domestic and overseas financial markets. It issued its first Eurobond in 2007, and since then has borrowed over US$15 billion. Since 2013 its external debt has been greater than its domestic debt. As of March 2022, the total debt stock was US$ 55 billion (78% of GDP) . The external component was estimated at US$ 28.4 billion representing 51.6% share of the total.
Domestic debt has been more expensive than external debt for a long time. The cost of borrowing from international capital markets ranges between 7% and 11% compared to domestic market’s 18%-22% .
Borrowing local is expensive for Ghana
A number of factors drive higher local borrowing costs. Here are some, though the list isn’t exhaustive.
First, local borrowing isn’t concessional. Concessional loans come with low interest and normally a grace period before principal repayments begin. But these loans are available only to poor countries that meet the criteria. Ghana doesn’t meet the criteria.
The second reason is related to high inflation and low domestic savings. Ghana’s inflation rate for April 2022 was 23.6%. No investor will invest at a rate lower than inflation because they will be making losses (negative real interest rate). Therefore, for the government to be able to attract investors, it will have to charge higher interest (usually above inflation rate).
A third reason that local debt is expensive is that Ghana’s domestic debt market is not yet deep and liquid. The small domestic debt market and a limited pool of funds means that restricts government to borrowing short-term and at higher interest rates.
The other reason foreign investors expect higher interest rates is because developing countries have a history of mismanaging their economies. Ghana has had its challenges of economic management . This is evident in the number of times the country had resorted to the IMF for a bailout. For the risk that foreign investors take, they expect a higher interest rates to compensate for the perceived risk.
Commercial foreign loans come with lower interest rates than domestic loans debt.
This is partly because external borrowing provides access to a vast pool of long-term funds held by international development banks or investors in international capital markets. This is true of loans with concessional or nonconcessional terms.
Longer maturities – which means longer periods of time over which debt can be settled – are also obtainable in foreign capital markets. This is because they are deeper and more sophisticated than domestic markets.
Long-term borrowing reduces public debt roll-over risks. For its part short-term borrowing worsens roll-over risks.
Foreign borrowing is routinely defended on the grounds that it avoids crowding out private borrowing and investment, which is what happens when domestic borrowing drives up interest rates. This argument is given force especially when domestic savings are very low or the outstanding domestic debt stock is already huge, and it is feared that the marginal cost of additional debt would have to keep rising to persuade local bondholders to lend more money to the government.
Grounds for coming home
There is a case to be made against foreign-currency loans. The factors include:
Foreign exchange risk: Even if the interest rate and other terms of a foreign loan are more favourable than domestic debt, the foreign loan might still be more expensive in the end. This is due to the inherent foreign exchange risk, whereby the cost of servicing the debt in local currency terms increases whenever the exchange rate depreciates (in a flexible or managed exchange rate regime) or is devalued (in a currency peg regime).
This worsens the burden of the debt on government revenue which is in local currency and raises debt service costs. At the same time, depreciation (or devaluation) raises the home currency value of outstanding foreign debt and depresses the foreign currency value of domestic revenue. This can lead to a country’s debt profile looking more vulnerable.
Investors may also perceive this situation as a deterioration of the government’s credit or default risk and demand higher interest rates on foreign borrowing.
By comparison, domestic debt doesn’t expose the government to currency risk and is therefore safe.
Crowding-out effects: When money raised abroad flows into the country it must be exchanged for the domestic currency which risks causing inflation as the inflows will result in an increase in money supply.
External borrowing can also trigger an appreciation of the domestic currency, thereby squeezing out exporters.
Debt service outflows: Interest paid on external debt is an outflow of resources abroad to foreigners, whose income and consumption are taxed by their own governments. It is not a domestic transfer that could yield tax revenue to the government. Accordingly, the domestic economy is worse off when foreign debt is serviced than when domestic debt is serviced. That is why there is the need to limit foreigners holding of the domestic bond.
Bigger debt crisis risk: When overdone, all forms of borrowing can plunge a country into a debt crisis or lead to a default. However, the risk of a crisis is bigger with foreign debt. First, what a government owes to foreign investors can balloon without government taking on a new debt. The cause would be a sharp weakening of the domestic currency against the currency in which the foreign debt is denominating.
Sovereignty: Dependence on external funds gives foreign creditors influence over domestic policy choices. This is facilitated, for example, through conditions attached to concessional loans given by international agencies, especially the IMF and World Bank.
In addition, disputes over foreign debt are typically adjudicated abroad whereas domestic debt is governed by domestic law, which the government has influence over.
Besides, to the extent that it is true, the argument that external sovereign debt acts as a disciplinary device over domestic policy decisions has a flip side. This is the fear that it could make a government beholden to foreign bondholders, whose expectations and interests would influence national policies, perhaps disproportionately and to the detriment of citizens’ interests.