Critically Assessing the Development Potential of Local Currency Bond Markets in Africa

The inability of developing and emerging economies (DEEs) to borrow in their currencies constitutes one of the key macroeconomic constraints and sources of financial vulnerability.  History - including experiences over the past decade - has shown that a large share of foreign currency-denominated debt carries the risk of devastating debt, exchange rate, and financial crises. These crises are frequently followed by general economic and social upheaval with wide-reaching implications for the fabric of the economy and society.

Over recent years, the African continent has been a renewed locus of such risks. For example, Ghana and Zambia, after facing financing and depreciation pressures, higher inflation and slowing economic activity, are aiming to restructure their external debt. This debt reaches almost 50% and 70% of their gross domestic product respectively. While Ghana seeks to restructure US$ 20 billion (two-thirds of the total external debt at the end of 2022), Zambia negotiated a deal to restructure US$ 6.3 billion of its debt in the hands of foreign governments and US$ 3 billion in the hands of private creditors.

The development of local currency bond markets (LCBMs) has been hailed as one potential solution to DEEs’ financial vulnerabilities. As we show in our paper, the drive to develop such markets has garnered particular impetus in the mid-2000s as international financial institutions and donor countries put LCBM development firmly on their agenda. For example, following the “G8 Action Plan for Developing Local Bond Markets in Emerging Market Economies and Developing Economies” several World Bank and IMF initiatives promoted the development of local currency bond markets[1]. At the G20 Cannes Summit in 2011, the African Local Currency Bond Fund was established by KfW[2] and the German government to promote corporate local currency bond markets in Africa. These initiatives were aided by ultra-low interest rates on global financial markets, which increased the attractiveness of higher-yielding bonds issued by DEE entities (in the African context mainly sovereigns). As a result, the share of local currency debt in total debt for low-income countries grew from around 19 per cent to reach 35 per cent by the end of 2021[3].

Our analysis shed light on the drivers, as well as potential benefits, costs, and risks of LCBM development in the African context. While the developmental potential of LCBMs has received considerable attention in academic and policy debates, there has been surprisingly little empirical examination of whether and to what extent LCBMs can provide sustainable and affordable long-term financing for the structural change so badly needed in those economies. We examine selected African LCBMs, including Egypt, Ethiopia, Ghana, Kenya, Nigeria, South Africa, and Uganda, drawing on semi-structured interviews with financial and policy experts as well as quantitative data from domestic debt management offices, ministries of finance, and the IMF.  

Specifically, we investigate four potential benefits of LCBMs: First, their ability to attract additional financial resources, especially if opened to foreign capital. Second, their contribution to the development and deepening of domestic financial markets, including the corporate bond market and patient domestic capital such as pension and insurance funds. Third, their ability to reduce financial fragility and external vulnerability through reducing domestic currency mismatches and the need to generate foreign exchange for debt service; and finally their impact on the efficiency of monetary policymaking, macroeconomic policy space, and the need to accumulate low-yielding foreign exchange reserves. In our analysis, we also consider whether three key domestic factors: the historically grown structure of the domestic financial system, state policy, as well as countries’ productive structure (in particular their degree of export diversification), make a difference to the developmental benefits of LCBMs.

Our results show that while LCBMs hold a lot of potential, their promotion in countries with little developed financial markets, low state capacity, and poorly diversified economic structures also carry risks, which need to be considered and carefully managed. With regards to the ability to generate additional and, importantly, stable financial resources, our evidence suggests that sadly this has not materialized so far. Whilst African LCBs attracted some interest during the period of high commodity prices and low-interest rates, this interest has since waned. Moreover, in many cases, the debt that has been issued has contributed to substantial interest rate payments which have weighed on social and productive expenditures.

With regards to financial development, concentrated domestic financial structures with little diversity have meant that LCBM holdings are either concentrated in domestic banks - which can harm productive sector lending - or by non-resident investors. Substantial LCBM holdings by non-resident investors seem to have exacerbated, rather than reduced, financial fragility and external vulnerability. This is so because foreign holdings of local currency assets shift the exchange rate risk to the foreign investor, making them more sensitive to (expected) exchange rate changes (a phenomenon also known as original sin redux; see e.g. Kaltenbrunner and Painceira, 2015; Hofman et al., 2020). This external vulnerability, in turn, has continued to constrain macroeconomic policy autonomy, skewing it towards maintaining external stability through foreign exchange reserve accumulation and foreign exchange interventions at the expense of directing monetary policy towards domestic economic policy goals and using foreign exchange reserves to ease severe balance of payments constraints. Moreover, we show that whilst, in theory, LCBMs might create more room for issuer countries to default, in practice domestic political and financial stability considerations - as well as the fear of reducing their attractiveness to international financial investors- might make policymakers reluctant to do so.

However, it is not all bad news. Countries with a slightly more diversified financial and productive structure, including the presence of more long-term domestic financial institutions such as pension and insurance funds, as well as more active state interventions such as capital account management techniques, can harness the financing potential of LCBMs. Thus ensuring the presence of domestic preconditions related to the domestic financial structure and state capabilities are important to further enhance the development potential of LCBMs. Policy lessons must go beyond acknowledging the need for diversified financial and productive structures, and the governance of financial markets, to also include identifying and challenging the conditions that constrain these possibilities. For example, economies most in need of financial measures that protect them from global financial cycles - such as capital account management techniques or domestic sources of patient capital are also those least likely to be able to implement them because of their vulnerable position in the global economy. Ultimately, the promotion of LCBMs for development must be accompanied by a rebalancing of global economic rules and norms that allow for more policy space within countries at the financial periphery.