Countries in receipt of IMF support often see rapid economic improvements. But local knowledge is crucial for bond investors chasing the ‘IMF trade’, says Carmen Altenkirch.
5 minute read
The roads are pitted with potholes, apartment blocks stand forlornly half-built and high-end restaurants are full of empty tables. The economic consequences of Angola’s failure to diversify away from oil are abundantly clear on the streets of its capital, Luanda.
I visited the city last month to investigate how economic reforms are progressing under President João Lourenço, who succeeded Angola’s long-serving leader José Eduardo dos Santos in September 2017. There have been tentative steps in the right direction. Lourenço has relaxed rules on foreign investment and announced some fiscal consolidation, among other measures.
Nevertheless, Angola still faces stiff economic challenges, and the country has been cited as a potential candidate for financial support from the International Monetary Fund (IMF). The Fund’s intervention may be no bad thing. History shows IMF programmes often kick-start a virtuous cycle of reform and economic growth in emerging markets, boosting asset prices and laying the groundwork for longer-term prosperity.
The IMF trade
Aware of these potential gains, some debt investors have begun to specifically target economies that could qualify for support. No longer considered a simple indication of a country in crisis, the presence of the IMF is often seen as a sign that its government is willing to implement beneficial economic reforms.
The so-called ‘IMF trade’ has proven particularly lucrative in recent years. Figure 1 indicates how recent IMF loan programmes have brought greater stability and boosted bond prices in many emerging-market economies. On average, zero-volatility or ‘z’ spreads on government bonds (a measure of the present value of cash flows over US Treasuries) widened by 150 basis points over the six months prior to staff-level agreement of an IMF programme, then tightened 200 basis points in the following year. Continued compliance with the Fund programme tends to lead to further spread compression.
On my trip to Africa I wanted to gauge the health of the economies in Angola and another sub-Saharan nation, Zambia; and assess whether they might be good prospects for IMF loans. It was evident both countries would benefit significantly from IMF support: Angola, to encourage cheaper multilateral financing and provide an anchor for the nascent reform agenda; Zambia, to help meet its urgent refinancing needs.
Figure 1: Government bond performance in countries with IMF programmes
After the end of a 26-year civil war in 2002, Angola’s economy grew strongly under former president Dos Santos, largely thanks to rampant oil exports. But the Dos Santos era was also marked by allegations of corruption and a failure to diversify away from hydrocarbons.
President Lourenço made some headline-grabbing changes soon after taking power last year, sacking Dos Santos’s son (head of the country’s $5 billion sovereign wealth fund) and daughter (chairwoman of the state oil company Sonangol) from prominent public positions. He also pledged to reduce the budget deficit to 3.9 per cent this year from 5.7 per cent in 2017.
However, deeper changes are needed to address Angola’s underlying structural challenges of oil dependence, low growth and a burgeoning debt burden. Although the exchange rate has been lowered, further devaluation will be required to reach the equilibrium rate. This could be politically difficult, as inflation is already running at 25 per cent.
Progress on diversification has been extremely slow and hampered by poor state investments in non-oil sectors. The government recently invested $1.2 billion in a textile manufacturer that has now all but shut down. Scope for further such investments is limited, with government debt at 64 per cent of GDP and creeping higher.
Neighbouring Zambia could also benefit from IMF assistance. Despite a recent rally in the price of copper – the country’s chief export – Zambia now has a mere $2 billion of international reserves, with roughly $1 billion in foreign-currency debt repayments due. There has been talk of restructuring a Chinese loan, but this would not provide short-term liquidity relief. A new Eurobond has been mooted, but this could be prohibitively expensive.
President Edgar Lungu, who has been in office since 2015, is more talk than action on reform. His priority appears to be winning re-election in 2021, and he has ramped up infrastructure spending to garner public support. Borrowing has increased in recent years and government debt now stands at $5.9 billion, or 48 per cent of GDP.
Lungu recently appointed a new finance minister, Margaret Mwanakatwe, replacing the well-respected Felix Mutati. The more cynical political analysts we spoke to in Zambia suggested Mwanakatwe, a former managing director at Barclays Bank of Zambia, has been instructed to balance the books where possible – while ensuring infrastructure spending is ring-fenced.
Mwanakatwe has announced some positive changes, though, targeting an increase in government revenue through improved efficiency, new property taxes and a clampdown on illicit alcohol smuggling. Such measures are intended to reduce the budget deficit from 6.1 per cent of GDP in 2017 to three per cent by 2021, but the limited scale of the measures makes this unlikely.
What does the IMF want?
While Angola and Zambia could glean advantages from an IMF programme, both countries will be wary of the tough conditions attached. The Fund’s policy prescription for countries high on debt and short on cash is well known: for those determined to hang on to a currency peg, the result is often devaluation (or a free float for braver administrations), followed by a mopping-up of excess liquidity in the banking sector.
Fiscal consolidation is high on the IMF’s agenda, preferably achieved by cutting excess current expenditure, along with efforts to broaden the tax base and improve efficiency. Curbing infrastructure projects – particularly those destined to produce white elephants – is a must. Countries must also improve their expenditure management.
Deal or no deal
So would Angola or Zambia be willing to meet these conditions? In Angola’s case, the answer, for now, must be a decisive no. Despite President’s Lourenço’s early reforms, there is a great deal of resistance among his colleagues in Angola’s ruling MPLA party to implement the sorts of changes an IMF programme would require – as well as an ideological objection to accepting outside help.
However, as Lourenço strengthens his position, he may be able to persuade party stalwarts that a full IMF programme would represent the only credible way to improve Angola’s medium-term prospects. IMF representatives in the country say dialogue with the authorities is good, and the new administration is implementing policies broadly in line with what the Fund would recommend. The issue now is how much further they are willing to go, particularly in terms of allowing the exchange rate to devalue and moving ahead with structural reforms.
The situation is different in Zambia. The newly-appointed finance minister has said she wants an IMF programme sooner rather than later. But Zambian finance ministers have been saying the same thing since at least 2015. The government has been reluctant to make the necessary policy changes, such as pulling back on infrastructure spending; as a result an exasperated Fund representative called an end to initial talks in February.
The IMF believes current debt trajectory is unsustainable. Zambia will need to agree to a more far-reaching fiscal consolidation plan and scrap at least some of its committed debt lines if it is to receive support. If the government demonstrates progress in this area an IMF deal is possible.
Hope for reform
Investors tempted to invest in Zambia on the basis of prospective IMF intervention should be aware that timing is key, however. Move too soon and returns can be eroded; too late and improvements are already priced in.
And of course, IMF support is not the only variable to consider for investors in emerging market debt. There are manifold economic and political issues at play that may determine the success or failure of a reform programme. Countries need to stay the course if the economic and market benefits of IMF support are to be realised over the longer term.
Failure to stay the course on an IMF programme, or falling off track shortly thereafter, has a negative impact on asset prices. Ghana, for example, failed to limit excessive election-related spending despite receiving an IMF loan in 2015. As a result, spreads continued to widen following the agreement (see figure 1). Or consider Pakistan and Tunisia, two other countries that have received IMF support. Figure 2 shows the z-spread versus the average among bonds with the same credit rating – a positive number shows that a country’s bonds are trading relatively cheaply, while a negative number indicates they are expensive.
Figure 2. Comparison of z spreads on 10-year bonds in B-rated countries
Pakistan’s bonds have under-performed their peers since the country reverted to its old ways following the completion of its IMF programme in September 2016. Pakistan’s reserves have dwindled as the central bank has sought to defend an over-valued exchange rate, and there is now talk of a new IMF programme. Tunisia’s bonds have also underperformed; like Ghana, Tunisia fell off track with its IMF programme as social pressures limited the government’s willingness to push through fiscal consolidation.
These cases show it is crucial that debt investors look beyond the presence or absence of the IMF and obtain sufficient on-the-ground insight to get a sense of a country’s the willingness to enact longer-term reforms – even if they are likely to encounter some potholes along the way.
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