BIS Working Papers
Central banks and debt: emerging risks to the effectiveness of monetary policy in Africa?
by Benedicte Vibe Christensen and Jochen Schanz
Monetary and Economic Department
JEL classification: demography, ageing, inflation, monetary policy
Keywords: E31, E52, J11
This publication is available on the BIS website (www.bis.org).
© Bank for International Settlements 2017. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.
ISSN 1020-0959 (print)
ISSN 1682-7678 (online)
Central banks and debt: emerging risks to the effectiveness of monetary policy in Africa?
Benedicte Vibe Christensen and Jochen Schanz
The last two decades have seen some major changes in the size and composition of debt in African countries. The relief of part of the public sector's external liabilities since the early 2000s lowered the level of outstanding debt in low-income countries to sustainable levels. However, in the 2010s, debt levels started to rise again. Initially, the increase reflected favourable external financing conditions on the back of higher commodity prices and improved terms of trade. Yet, when the tide turned and commodity prices started to fall again in 2014, debt continued to rise in many countries as fiscal spending exceeded subsiding revenues. Thus, debt has become an issue of concern again, not only because of its macroeconomic impact, but also because of its possible adverse effects on the conduct of monetary policy.
High debt can undermine the effectiveness of monetary policy regardless of the level of development. Whenever the exchange rate comes under pressure, high debt, especially if foreign currency-denominated, can give rise to a difficult policy trade-off - limiting exchange rate depreciation and capital outflows through higher interest rates, on the one hand, and containing borrowing costs, on the other. And high government debt more specifically may give rise to pressure on central banks to keep interest rates lower than warranted or even to cover funding needs directly.
In most African countries, debt has not reached levels at which it risks rendering monetary policy ineffective. However, the balance of risk may change if debt continues to increase, particularly in a period of rising trade protectionism and rising interest rates abroad. While central banks can influence the level and composition of debt held or owed by the financial sector if they have supervisory powers, they can only influence government debt indirectly, notably through communications, either behind closed doors or publicly. Institutional arrangements for monetary policy, such as inflation targeting accompanied by operational independence of central banks, might put discipline on fiscal policy and thereby hinder the accumulation of debt and reduce pressure on inflation.
Focusing primarily on the largest component of debt, government debt, the following sections describe recent trends, discuss how these trends can pose risks to the effectiveness of monetary policy, and examine how central banks might use their influence to address them.
Recent trends in debt
Africa consists of a diverse group of countries at various stages of development. That said, most differ from the majority of advanced (AEs) and emerging market economies (EMEs) in other regions by having relatively low levels of both public and private sector debt. Their economies typically rely on income from a small number of sectors, often commodities. Therefore, their terms of trade, output growth and fiscal revenues are much more volatile. As a result, debt can rise quickly in response to adverse developments, as expenditures cannot adjust swiftly enough to incomes. Indeed, this has been so since the 2014-16 downturn in commodity prices.
Private and government debt, by country type and borrowing sector
How has African countries' debt evolved recently? 3 Following the relief of part of the public sector debt in the 2000s, public and private sector debt started to increase again (Graph 1), from both domestic and external sources.
External debt has risen by almost 10 percentage points since 2010, to about 40% of GDP but with considerable differences among countries. In a few countries, external debt has doubled during this period relative to GDP (eg Cameroon, Liberia, Mozambique, Senegal and Zambia). While the composition of lenders has changed - in particular, China's share of Africa's external debt has increased rapidly, reflecting that country's growing economic engagement in the region (see Box 1) - key lending terms have remained broadly constant: only 10% of outstanding debt matures in less than a year, and new lending has an average maturity of just over 20 years. With roughly a third of external debt on concessional terms, average interest rates remain low (1.75% on new commitments). Four fifths of external debt is owed by the public sector. Governments' external debt vis-a-vis private sector lenders has mostly taken the form of international debt securities, while private sector borrowers have relied more on bank loans (Graph 2, centre panel).4 Repayments of international debt securities will be peaking in the mid-2020s (right-hand panel).
Information about domestic debt is sparser. Household debt appears to be relatively small relative to GDP in most African countries. Liabilities of commercial banks are overwhelmingly towards residents, to some extent in foreign currency (Annex Tables A1 and A2). A significant share of their claims are on the government and the central bank (Annex Tables A3 and A4). Governments have increasingly borrowed in local currency in the form of bonds. Most of these bonds are held by residents, despite a gradual increase in foreign ownership (Annex Table A7).
The reasons for the increase in debt during the 2010s vary significantly across time and countries, and involve both a greater ability and a need to borrow. A greater ability to borrow has resulted from debt relief, improved fundamentals and favourable global financial conditions (Graph 3). A greater need reflects, in particular, negative terms of trade shocks (Christensen (2016)). Not only did these shocks weigh on economic growth and fiscal revenues, but they may also have increased the size of governments' contingent liabilities to banks and state-owned enterprises. For example, banks' non-performing loans have risen to about 11% of total loans, or 22% (net of provisions) of capital, partly because highly indebted governments had incurred arrears vis-a-vis their suppliers (simple averages over data shown in Annex
Table A5). In addition, loans to government-owned enterprises have played a prominent role in countries such as The Gambia and Mozambique. Debt-financed spending on infrastructure has also boosted government debt (eg in Kenya).
Does high debt reduce monetary policy effectiveness?
The level and structure of an economy's debt, especially if denominated in foreign currency, can undermine the central bank's ability to pursue its policy objectives. This section recalls the channels that appear most relevant for Africa.
The first channel works through foreign currency debt levels and implied currency mismatches. For foreign currency debt, financial conditions depend directly on the monetary policy of the country issuing the relevant currency - in the case of Africa, mostly the US dollar, but also the euro. Higher interest rates in the United States and the euro area, therefore, tighten financing conditions and put pressure on domestic currencies.8 Depreciating local currencies might also give rise to vulnerabilities in sectors in which foreign currency assets or revenues are insufficient to match foreign currency liabilities. This may be an issue for some banks in Africa (the banking sectors in The Gambia and Rwanda, for example, had small negative net open foreign exchange positions in 2017). In countries with substantial foreign investor participation in domestic currency markets (eg Ghana, Nigeria, South Africa and Zambia), depreciating local currencies may also induce unhedged foreign investors to repatriate investments to limit valuation losses in their home currency (Bruno and Shin (2015)). More broadly, high external debt makes domestic borrowers more vulnerable to swings in market sentiment. When external financial conditions tighten, and the exchange rate comes under pressure, the central bank may face a difficult balancing act, between attempting to limit exchange rate depreciation and capital outflows, on the one hand, and containing borrowing costs, on the other.
The second channel works primarily through domestic currency debt levels. Changes in policy rates have a larger impact the higher the level of domestic debt. Central banks may come under greater pressure to keep interest rates lower than warranted and to ease the refinancing burden, or even to cover funding needs directly via loans or bond purchases. While central bank funding of the government has increased in some regions (Annex Table 6) and contributed to a decline in reserves, it has rarely triggered inflation bursts - counter-examples are Zimbabwe during 2008-09 and South Sudan in 2016.9 Across the region, monetary policy frameworks have generally been strengthened (for example, by introducing inflation targeting) and many countries have implemented limits to curb direct deficit financing.
What could central banks do to mitigate these risks?
Many African central banks are able to influence borrowing patterns and risk-taking in the private sector in their capacity as macro- or microprudential authorities.11 Yet they cannot control the size of sovereign debt in the same way, and their sway over its composition is typically very small. This is a concern, given that it is public sector debt, by virtue of its size, which continues to pose the most substantial risk to the effectiveness of monetary policy in Africa.
As the experience of other emerging market economies has shown, institutional factors play an important role in ensuring that monetary policy remains effective. These factors include prudent fiscal management (in particular fiscal rules), sound prudential supervision and clear objectives for the central bank (including a prohibition in law to extend loans to the government) combined with operational autonomy in achieving those objectives (including curtailing the government's ability to recall a central bank Governor).
Pursuing reforms that strengthen their autonomy could therefore be one way forward for some central banks. Indeed, the independence of central banks appears to have come under pressure in some African countries (Kganyago (2018)). The adoption of inflation targeting might be able to help avoid an increase in debt - partly because inflation targeting helps stabilise the economy, and partly because the public announcement of an inflation target provides greater accountability for missing the target, thereby helping to put pressure on governments to tighten fiscal policy (Tapsoba (2010)). That said, if debt nevertheless rises, inflation targeting alone cannot ensure that monetary policy remains effective.
But even within the existing institutional frameworks, there may be a number of options central banks have to influence public sector debt.
An obvious avenue is debt management. To the extent that central banks have a role, they could work with the government to increase debt tenors and ensure that the timing of debt service does not overwhelm the fiscal budget. For example, the National Bank of Rwanda participates in joint committees with the Treasury and the debt management office, which serve to refine the government's macroeconomic policies and forecasts. In Botswana, the central bank advises state-owned companies seeking to raise debt. However, the effectiveness of such arrangements clearly depends on a desire to take advice into account. In addition, there may be a risk that too close an involvement infringes upon the central bank's independence. One way to limit such risks is a more indirect role. For example, the Central Bank of Kenya embarked on an initiative to develop the country's debt markets, in part to ensure government access to longer-term domestic currency funding.
An alternative avenue for the central bank to build support for a fiscal policy that does not endanger monetary policy effectiveness is communication. Designing such a strategy, however, is not straightforward.14
One aspect is the appropriate messaging. Central banks might find it difficult to get the government's attention: for example, suggestions to rein in spending might be brushed aside with reference to the need to fund infrastructure investments. Too timid warnings of fiscal difficulties may not acquire sufficient traction. Too forceful ones might cause lasting damage to the central bank's relationship with the Treasury or trigger undesired market volatility. To guard against the criticism that the central bank exceeded its mandate, it might be useful to point out the disadvantages of excessive debt for monetary policy rather than criticising fiscal policy more generally. How candid central banks can be depends on their mandates, the degree of independence and even country-specific implicit norms. As a result, the extent to which criticism is acceptable, and how far it may be voiced in public, is bound to vary across countries.
Another aspect is the optimal frequency of communications. Risk warnings are bound to receive more attention when they are issued judiciously. Frequent warnings, in contrast, are likely to lead to communication fatigue.
The third aspect concerns available data. Credible communications require appropriate data to support the central banks' own analysis and enable others to conduct independent assessments. In many African countries, debt statistics are incomplete - lacking, for example, information about publicly guaranteed debt and debt incurred by public enterprises. Central banks have a key role to play in collecting and publishing such statistical information.
In a period of rising trade protectionism and higher interest rates abroad, there is renewed urgency to ensure that debt, already on an upward path, does not impede the effectiveness of monetary policy in African countries. Given African economies' integration in global value chains, protectionism would probably lower export revenues and raise demand for external finance precisely when tighter monetary policy in advanced economies pushes up external funding costs. The increase in funding costs might be felt broadly across African countries as foreign investors may not differentiate much between frontier economies.
While central banks can affect the level and composition of debt held or owed by the financial sector if they have supervisory powers, they can only influence government debt indirectly, notably through communications. Advising the government and state-owned companies on debt management and macroeconomic developments might help slow a build-up in debt. Should debt nevertheless rise, certain institutional arrangements, such as rules against direct funding of the government budget, setting an inflation target for monetary policy, and operational independence, could help protect the effectiveness of monetary policy. Pursuing reforms that implement such arrangements could be one way forward for some African central banks.
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Unless otherwise indicated, countries are grouped as follows: