Ethiopia’s announcement of plans to restructure its external debt under the G20’s Common Framework this past Friday took markets, and us, by surprise (see here for the announcement and here for our initial thoughts). However, it is still not obvious what Ethiopia’s intentions are or whether Ethiopia’s eurobond will be included in the restructuring (although it seems clear that under the Common Framework it should be).
One source of confusion may simply be that the Common Framework is new and so far untried. The Common Framework is specifically intended to bail in all creditors in cases of unsustainable debt (solvency situations rather than liquidity situations, which is the focus of DSSI). It may be that instead of a full-blown restructuring with PSI, Ethiopia is seeking relief beyond DSSI, Angola-style, which could avoid the need for PSI. Moreover, it is not clear what is meant to happen if the country falls in the grey zone between needing more cashflow relief than DSSI provides but where debt is not unsustainable under the Common Framework; presumably this means an ad hoc treatment.
According to a government statement, it “is currently updating its public debt sustainability assessment [DSA] with the assistance of the IMF and preparing for upcoming discussions with official creditors. Only once these discussions are completed will the Ministry [of Finance] be in a position to inform its other creditors of the need for broader debt treatment discussions in accordance with the comparability of treatment rule.”
This means that the decision on the perimeter and terms of the restructuring will be guided in large part by the outputs of the IMF’s DSA, which will determine what is necessary to set debt on a sustainable path (assuming the IMF find debt to be unsustainable in the first place). The IMF last conducted a DSA for Ethiopia in May, deeming Ethiopia’s debt to be sustainable but with a high risk of external and overall debt distress (with two external debt indicators breaching their thresholds under the baseline forecasts).
More recently, the IMF stated in August that “The authorities’ efforts to control public sector borrowing and reform the public sector will support a continued decline of the external debt to GDP ratio” and added that “Additional debt reprofiling from external creditors would also help reduce debt vulnerabilities.” We assume that this refers to the need for a liability management exercise and further relief from the official sector, through DSSI or otherwise, rather than a restructuring or PSI.
Of course, it is possible that there has been slippage since then, as the full impact of Covid becomes visible and especially given security concerns in Tiray and the border dispute with Sudan. But forecasts from the IMF’s October 2020 WEO continued to be rather sanguine, with real GDP growth falling to 0% in FY 2020/21 (through 7 July) before settling around 8% by 2024/25, the budget deficit falling below 2% of GDP by 2021/22 after only marginal slippage from 2.5% to 3.5% of GDP last year, and public debt rising slightly from 56.1% to 58.5% of GDP this year before falling steadily to 43.3% of GDP by 2024/25.
Overall, Ethiopia’s solvency indicators are not flashing any major warning signals. Putting aside forecasts for a substantial decline in its debt stock in the coming years, its debt composition is quite favourable as well (44% of external debt is on concessional terms, new external debt has an average maturity of 30 years, Ethiopia’s weighted average interest rate is only 0.9%, and interest payments were only 4.3% of tax revenue in 2019/20). With such a highly concessional debt mix already, it is hard to imagine what else Ethiopia hopes to accomplish with a restructuring from the solvency perspective.
That said, liquidity indicators are more concerning and reserves remain worryingly low at only US$3.3bn (2.1 months of import) in October, per central bank estimates. This stands against amortizations of cUS$1.8bn annually over the next three years, with total external debt service reaching 22% of exports of goods & services last year. Under its IMF program, Ethiopia plans to fill its external funding gap with funding from the IMF and other identified and unidentified donors, privatisation proceeds, and debt service reprofiling, which should be sufficient to set reserves on a firm upward trajectory.
However, if current account receipts drop or funding fails to materialise, an external funding gap could re-emerge. While the IMF pencilled in US$1.25bn of official transfers annually over the next three years, reports of atrocities in Tigray since the outbreak of conflict in November and the ongoing blockage of needed humanitarian aid to the region may prompt donors to pull back or withdraw funding. The EU has suspended EUR90mn of budget support. This follows the suspension of US$130mn of aid from the US due to Ethiopia’s dispute with Egypt and Sudan over water rights on the Nile. While the loss of this aid is not a watershed, it could foreshadow the postponement of aid from more donors in the future if Ethiopia does not urgently take efforts to restore peace in Tigray. In addition, the IMF’s May forecasts were predicated on a substantial rise in FDI (which has declined sharply in recent years and may be hurt further by the conflict) and privatisation proceeds that have yet to materialise (with the potential for further delays to the Ethio Telecom privatisation process).
In addition, investors may be concerned about lack of data transparency and that the liquidity situation is worse than reported. While official data through last June puts reserves at US$3.2bn (in line with the IMF’s May estimate), much time has passed since then and IMF IFS data on Ethiopian reserves has not been updated since January 2020. With official data on Ethiopia’s external accounts running only through June, it is certainly possible that the BOP has deteriorated significantly since, although hard data to testify to this is lacking. Adding some fodder to this view, the IMF programme itself appears to have stalled, as the first review has still not gone to the Board following the staff level agreement reached last August. If the BOP situation is worse than reported and Ethiopia is in the midst of a BOP crisis, this would go a long way towards explaining the rationale for a restructuring exercise.
Regardless of its motives, it seems the government has determined cashflow relief under DSSI to be insufficient, and will likely seek similar relief over a longer time frame (beyond June 2021) and/or across a wider range of creditors to ease liquidity constraints. From this perspective, entering the Common Framework may have seemed the quickest and easiest path to broaden the scope of cashflow relief. If the intention is simply to bring non-Paris Club creditors (like China) into the process, it is not clear that PSI would be necessary or even desirable. Indeed, Ethiopia’s lone eurobond comprises less than 4% of its public external debt stock and annual service is a mere US$66m of interest until the bond matures in December 2024. And we know China has kept some of its lending entities outside DSSI, dampening the cashflow savings from this initiative.
Regardless, the limited information we do have on the Common Framework is very clear about the need for wider creditor participation, including PSI. Indeed, the G20 Leaders' Summit in Riyadh in November laid out comparability of treatment as a core principle of the Common Framework, “with broad creditors’ participation including the private sector." This is in line with the Evian treatment, the most recent Paris Club debt relief framework, in which participants are obligated to seek debt relief from non-Paris Club commercial and bilateral creditors on comparable terms.
With that said, it is unlikely that Ethiopia’s bilateral creditors will agree to a ring-fencing of Ethiopia’s eurobonds. China accounts for 30% of Ethiopia’s external debt stock and 45% of external debt service in 2021, so their support will be a necessary precondition for any restructuring under the Common Framework. However, bondholders are likely to push back aggressively against any attempts to include private creditors, arguing that Ethiopia remains solvent and that the bond is not a meaningful proportion of the total. Creditors have taken an assertive stance in Zambia’s restructuring, and the argument for restructuring is far more persuasive there than it is in Ethiopia. And Angola, with a much more onerous debt burden, avoided PSI by securing very generous restructuring terms from China (beyond DSSI), although that was pre-Common Framework.
Debt sustainability analysis
To see whether PSI will be a necessary part of Ethiopia’s debt restructuring, we run our own DSA to predict the results of the IMF-guided process now underway. Our baseline assumptions are pulled from the IMF’s October 2020 WEO (see table above), but we also include an alternate scenario in which the primary deficit is unchanged from 2019/20 and one that applies a shock across five key variables (see below). Under our baseline scenario public debt falls to 46.5% of GDP by 2024/25, while under the constant primary balance scenario it falls to 55.1% (with the 3% primary deficit sitting just below our estimated debt-stabilising deficit of 3.2%), and under the combined shock it rises to 70.6% (concerning but still not back-breaking from the solvency perspective).
We can then compare the outputs to the IMF’s five key debt sustainability thresholds. Under the baseline scenario, the PV of external debt-to-exports and external debt service-to-revenue ratios breach sustainability thresholds throughout the forecast horizon, while the external debt service-to-revenue ratio breaches the threshold in 2024/25 only (resulting from the US$1bn eurobond amortization in December 2024). In the constant primary balance scenario, the PV of total public debt-to-GDP also breaches its threshold in 2020/21.
These results are not substantially different from the IMF’s DSA in May, which deemed debt sustainable. However, to replicate the IMF’s DSA process more completely, we also run several shocks. Our baseline and constant primary balance estimates for the IMF’s five key sustainability thresholds, along with their values under various shocks, are illustrated in the charts below:
*Notes: Green = substantial policy space, yellow = some policy space, red = limited policy space; PV discounted at 5%; Shocks include GDP growth, primary balance, and export growth (1 standard deviation decline from baseline), exchange rate shock (30% devaluation in 2020/21), market financing shock (400bps increase in external financing costs and 5-year decline in weighted average maturity), and combined shock (all five shocks at once); External debt includes public and private sector (private sector averages 3.1% of GDP over medium-term, per IMF estimates); External debt service includes interest and amortizations; Exports include goods and services
Our DSA does not seem to point to an obvious need for debt restructuring, despite elevated risks. While low reserves and weak exports are certainly cause for concern, Ethiopia retained market access before last week’s announcement (its lone eurobond traded above par with a mid-YTM of 6.35%) and was in a good position to reduce liquidity risks by “reprofiling” official debt as advised by the IMF in August (including via DSSI) rather than launching a full-blown debt restructuring.
That said, the train may have already left the station. If Ethiopia decides to forge ahead with its plans to restructure under the Common Framework, then the comparability of treatment principal may make PSI a necessary component regardless of whether there is a strong underlying case for it (although that is likely to make for challenging negotiations with bondholders).
We present several possible restructuring scenarios to model possible recovery values.
In scenario 1, Ethiopia implements a restructuring across all creditors, public and private, under the Common Framework, with a 2-year grace period on interest and 5-year maturity extension, 10% haircut, and 50% coupon reduction (similar to what we saw last year in Argentina, from a much worse starting point in terms of public debt/GDP, and Ecuador, from a similar starting point). This will achieve meaningful liquidity relief (US$675m in interest payments annually over the next two years and US$300m annually over the following three, and postponed amortizations averaging nearly US$2bn annually between now and 2025). We think that Ethiopia will be hard-pressed to argue for such an aggressive approach while most of its solvency indicators remain healthy, and it is likely to face strong opposition by bondholders who will argue (convincingly, we think) that such an operation is premature and unnecessary, but include it for illustrative purposes as a stylised worst case scenario.
Scenario 2 offers a more palatable – but still fairly aggressive – approach based on a 2-year grace period and 5-year maturity extension, but without the haircut or coupon reductions. This seems like a more likely route, a compromise between the stated requirement for PSI by the G20 in Riyadh and a more benign treatment, although it is still likely to meet resistance from bondholders (although maturity extension is likely to be unavoidable so that official sector money is simply not used to pay bondholders). This scenario also provides US$675m in interest payments annually over the next two years and postpones annual amortizations of US$2bn, but will see interest payments resume in full (and with capitalized interest added in) from 2023 onward (though without the burden of the US$1bn January 2024 eurobond amortization in December 2024).
Scenario 3 follows the Belize approach, issuing a consent solicitation to bondholders to capitalise interest for a limited period (which we conservatively assume will be for two years, or through the end of 2022). This has the advantage of proactively achieving PSI in a way that does not unduly impact bondholders but may be sufficient to convince other bilateral creditors outside the auspices of DSSI (namely China) to offer more relief. Indeed, a formal consent solicitation has become a much more common approach to defer debt service payments post-Covid, although in Ethiopia’s case it would be unusually proactive (the next coupon payment is due in June) and bondholders may vote against it if they view it as unnecessary (like they have in Zambia). However, we doubt bondholders would support such a deferral without a commitment from the authorities to greater transparency and having a credible recovery plan. That said, if this approach successfully brings private and official bilateral creditors to the table, plus non-official Chinese creditors, it would save US$385m of interest and US$755m of principal payments in 2021 (and we assume a similar amount in 2022).
Lastly, scenario 4 follows the Angola approach by securing additional bilateral relief from China without the need for PSI, so the bonds aren’t touched. Like Ethiopia, a large portion of Angola’s public external debt is owed to China (45% of the stock and 48% of debt service in 2021). Angola was able to obtain debt relief last year through the DSSI and directly from China without bilateral creditors forcing PSI, and with much weaker solvency indicators than Ethiopia (public debt reached over 120% of GDP last year versus 56% for Ethiopia) and a higher proportion of private debt (eurobonds are 22% of the external debt stock and 11% of service in Angola versus 4% and 3%, respectively, in Ethiopia). This would, of course, be the most favourable scenario for bondholders, and would still offer significant liquidity relief over the next two years if interest is capitalised through end-2022 (the same as scenario 3, minus US$66m of annual eurobond interest).
It is possible that this is what Ethiopia was driving at in the first place, and simply meant to obtain debt relief from a broader range of official sources and over a longer period than DSSI allows, rather than entering the Common Framework in a more formal sense. However, it is not at all clear that China would agree on a similar approach for Ethiopia (Angola is a strategic source of oil imports for China, whereas Ethiopia is not), and it could choose instead to push for comparability of treatment. IIndeed, one criticism heard of DSSI so far is that China has backtracked on previous promises to provide debt relief (which may have contributed to the need to restructure), and it is possible that they have refused to provide further relief without evidence that other official and private sector creditors are willing to do their part.
Below, we outline these four scenarios and estimated recovery values:
With a mid-price of US$95.5 at the time of writing, bonds seem to be optimistically pricing in something between scenarios 3 and 4, assuming an 8% exit yield. While there is undoubtedly some upside if an Angola- or Belize-like restructuring materializes (especially if the exit yield falls back to last week’s level of under 6.5%, which is unlikely given the implication of greater liquidity constraints and less willingness to pay stemming from restructuring plan), the risk does appear to be skewed to the downside with a further drop in prices more likely than a rebound (especially if clarity is not quickly provided and bonds adjust to prices more commensurate with distress and/or ratings agencies respond to recent events with a downgrade).
For now, we maintain our Hold recommendation on Ethiopia ‘24s until there is further clarity on the perimeter and terms of the restructuring.
Fixed income strategy: Our top 5 picks, 23 December
Conflicting reports on the state of the conflict, 2 December
Ethiopia on the brink of civil war, 4 November
Conversation with the National Bank of Ethiopia, 19 October