Game over for Zambia?

Read this article to understand:

• What Zambian debt restructuring could imply for other countries
• Why China will play a key role in negotiations
• What markets are pricing in in terms of recovery rates

On June 9, 2012, Zambia beat Ghana 1-0 in a regional qualifier for the 2014 World Cup. The venue was the Levy Mwanawasa stadium in Ndola, a small city of 475,000 people in the heart of Zambia’s copper belt.

Interest in the Chipolopolo (Zambia’s national team nickname) was running high after their maiden Africa Cup of Nations title four months earlier. Attendance for what marked the multi-purpose stadium’s inaugural event exceeded the official capacity of 49,800.

Built by the Shanghai Construction Group at a cost of $65 million – financing was provided by China’s Ministry of Commerce – the stadium is one of the more egregious examples of white elephants now littering the continent. Since that win over Ghana, it has stood largely deserted, rarely attracting crowds of more than 5,000.

Within two years of its completion, the Chipolopolo had a new home: the 60,000-seater National Heroes Stadium in the capital, Lusaka. Also built by the Shanghai Construction Group, at a cost of $94 million, it too is in danger of becoming a white elephant.

This is an all-too-familiar theme playing out over a continent that has binged on Chinese capital: both through loans to public and private sectors and foreign direct investment. The China Africa Research Initiative (CARI) estimates that between 2000 and 2019, Chinese financiers committed US$153 billion to African public sector borrowers.¹

While only a fraction of the money has been lavished on grandiose stadia – CARI reckons at least 80 per cent have financed economic and social infrastructure projects, with the largest share going on transportation – many of these schemes have been of questionable economic or social benefit.

For example, in 2017 Kenya opened a new $4.7 billion railway linking the port of Mombasa with the capital Nairobi, 484 kilometres away. Financed by Chinese loans, built by Chinese companies and benefiting from Chinese expertise and technology, the project has been marred by value-for-money and environmental concerns.

China becomes a vital economic ally

Having overtaken the United States to become Africa’s biggest trade partner in 2009, China is now a vital economic ally for many of the continent’s nations. That said, although it remains Africa’s largest bilateral lender by some distance, Chinese lending has been in decline for several years.

As shown in Figure 1, Chinese annual lending commitments peaked in 2016 at US$28 billion. Moreover, when Angola, which refinanced a significant amount of existing loans in 2016, is stripped from the data, lending to Africa has been falling since 2013, somewhat ironically since that was also the year China launched its Belt and Road Initiative (BRI).

Figure 1: Annual loans to African countries by Chinese lenders (US$ bn)

Source: Johns Hopkins University SAIS China-Africa Research Initiative. Data as of April 8, 2022

Two forces are likely responsible for the decline. Domestic political pressure is causing some African governments to think twice about taking on new Chinese debt. This reflects mounting anger and political opposition to the disadvantageous terms on offer, with loans often collateralised against oil reserves and other natural resources. Tying loans to the use of Chinese labour and goods has added to the disquiet.

In 2019, Beijing said that, as part of a much bigger US$19 billion loan agreement with Ghana, it would finance US$2 billion worth of rail, road and bridge networks. In return, it will be granted access to five per cent of the African nation’s bauxite reserves.

The deal drew stinging criticism from environmental activists, political opposition, and international government investment partners, with one political risk consultancy highlighting a lack of transparency and the increasing threat to debt sustainability.²

Chinese lenders overexposed

More significantly, China’s appetite for lending appears to be waning. Efforts to boost flagging rates of domestic economic growth are causing it to turn inwards, a trend that seems to have been accelerated by the pandemic. But perhaps of most concern to Beijing, a high degree of concentration has left its lenders heavily overexposed to several of the world’s more heavily indebted nations, among them Zambia.

Figure 2: Chinese lending to central governments (per cent of GDP)

Note: Purple bars = countries which are at/or near debt distress (IMF classification). Source: China Africa Research Initiative, April 8, 2022³

Chinese financing to the 138 countries targeted by BRI fell 54 per cent to US$47 billion in 2020, the lowest amount since the initiative was unveiled. The decline persisted into the first half of 2021, with BRI financing down 30 per cent year-on-year to US$19.3 billion.⁴

In Africa – home to 40 of those nations involved in the BRI – Chinese bank financing for infrastructure projects fell from US$11 billion in 2017 to US$3.3 billion in 2020, according to a report by international law firm Baker McKenzie.⁵

China has not only been a source of lending for hard-up African nations, it has been a huge investor in the region too. Since 2010, Chinese companies have invested far more in the continent than their American counterparts, as seen in Figure 3.

Figure 3: Cumulative FDI flows to Africa, since 2010 (US$ bn unadjusted)

Source: Johns Hopkins University SAIS China-Africa Research Initiative. Data as of April 8, 2022

This is partly explained by Chinese companies’ desire to secure access to Africa’s vast natural resources, in particular industrial metals and fuels. However, as with its lending, there are signs Chinese foreign direct investment (FDI) may also be going into reverse.

Figure 4: China-Africa FDI stock, change from previous year (US$ bn)

Source: Johns Hopkins University SAIS China-Africa Research Initiative. Data as of April 8, 2022

The withdrawal of loans and investment is a big blow for countries hoping to secure capital to build highways and rail lines linking landlocked countries to ports. The continent faces an estimated annual infrastructure investment deficit of around US$100 billion, according to the African Development Bank.⁶

The fact it is happening at a time when many countries are reeling from the pandemic is doubly concerning. The worry is that, as FDI dries up, this will further depress economic activity, making debt burdens even more onerous.

Zambia became Africa’s first pandemic-era sovereign default when it bowed out of a $42.5 million Eurobond repayment in November 2020.⁷ The country’s woes are a warning that a debt tsunami could engulf the continent’s most heavily indebted nations.

Hidden debt?

This is particularly true of those countries that have borrowed heavily from China for two reasons. Firstly, there is concern the true scale of borrowing from China may be higher than some countries admit. Secondly, the fact bilateral loan terms are often hidden means Chinese creditors may be able to secure preferential treatment in the event of defaults.

The World Bank is worried true debt could be underreported. Its first concern is there is often a lack of oversight of the non-state guaranteed borrowing activities of state-owned enterprises. State guarantees given in the context of public-private partnerships (PPPs) are a second reason debt may be going underreported.

The World Bank says the scope of guarantees offered to make PPPs look viable may be “substantial”. They include loan repayments, guaranteed rates of return, minimum income streams, guaranteed currency exchange rates and compensation should new legislation affect an investment’s profitability.

“Current accounting practice permits governments to keep the costs and liabilities associated with PPPs off-balance sheet, thus circumventing budgetary constraints and obfuscating scrutiny by the national legislature,” the bank warns.⁸

In October 2021, Zambia said that, as of that June that year, total public debt was just shy of US$27 billion, equivalent to just under 125 per cent of 2021 GDP, according to IMF estimates.⁹ Of that, US$14.67 billion was external debt, including US$5.75 billion owed to Chinese entities.

The admission followed a September 2021 report by CARI in which Zambia and its state-owned enterprises were noted to have entered into at least 53 different loan contracts between 2010 and 2019. In what was described as an example of “poor fiscal transparency, oversight and co-ordination”, Zambia was said to have “misclassified” Chinese debt which, as a result, was larger than the government had been admitting.¹⁰

Clouded in secrecy

Compounding investors’ concerns, even where Chinese debt is known about, the terms are usually not. For example, the Kenyan government recently refused to make public the loan contracts for its Chinese-built railway in response to a court petition by two activists. It said they have non-disclosure clauses and releasing them would amount to breaching a bilateral agreement, impairing relations with China.¹¹

During the second half of the 20th century, the Western world organised restructurings of poor nations’ debt by using the “Paris Club” framework. This enabled creditor nations to cut deals backed up by institutions such as the IMF and the “London Club” of commercial lenders.

However, negotiations were rarely straightforward. While key Chinese creditors – notably the China Development Bank and the Export-Import Bank of China – are profit-seeking enterprises, they also have close links to the Chinese state, which blurs the lines between commercial and bilateral debt. Negotiations are likely to be further complicated by the fact China, which is not a member of the Paris Club, has become such an important creditor to so many low-income countries.

Figure 5 from the IMF shows that a decade ago low-income countries had about US$80 billion of public external bilateral debt, two thirds of which was provided by Paris Club lenders. Today, however, not only do these debts top US$200 billion, less than a third comes from the Paris Club – nearly twice as much is owed to China.

Figure 5: Public external debt of low-income countries to non-Paris club creditors (US$ bn)

Source: ‘International debt statistics’, The World Bank. Data as of October 10, 2021. Published on IMFBlog¹²

In December, Zambia pledged to cut its fiscal deficit to 6.7 per cent of GDP this year, down from ten per cent in 2021, and said it will aim for surpluses thereafter, as it agreed a US$1.4 billion bailout with the IMF.¹³

Equal burden sharing

However, while this has bought the country some much needed breathing space, it remains to be seen how it will balance the competing interests of creditors. In February last year, Zambia opted for a debt restructuring under the so-called ‘Common Framework’. Launched by the Group of 20 major economies and the Paris Club of official creditors in 2020, it aims to provide debt relief for countries eligible for repayment moratoriums under the Debt Service Suspension Initiative. Central to the framework is the idea of equal burden sharing, so if one creditor takes a 30 per cent haircut, all of them will.

The Zambian government has stated all creditors will be treated equally. But bondholders are concerned Chinese lenders may demand preferential treatment and any money they give up might simply be used to pay off the Chinese.

When it comes to thinking about China’s role in debt relief, it is important to highlight there is no China Inc; each lender has a different strategy in terms of renegotiating debt. It is also important to understand different types of debt tend to be treated differently.

That said, although Chinese lenders have applied Paris Club terms to some historic debt reschedulings at the borrower’s request, they have tended to go about their business quietly, on a bilateral basis, tailoring programmes to individual circumstances.

A Center for Global Development report in November 2020 found evidence Chinese lenders had responded very differently when confronted with a “low stakes” debt rescheduling involving Seychelles and a “high stakes” case involving the Republic of Congo.¹⁴

In the case of the former, where China’s exposure was small, the report said Beijing offered extensive debt relief comparable to that provided by Paris Club creditors. In contrast, with the Republic of Congo, where Beijing had greater exposure and the borrower had limited leverage, Chinese lenders had enough bargaining power to receive more favourable terms than Paris Club creditors. While the Export-Import Bank of China reprofiled its debt, it upped the interest rates and thereby benefited in net present value terms.

Will China flex its muscles?

Chinese lenders’ leverage is often enhanced by the way in which debt contracts are worded. A 2021 study published by the Capital Markets Law Journal analysed 100 contracts between Chinese state-owned entities and government borrowers in 24 developing countries.¹⁵ Comparing them with those of other bilateral, multilateral, and commercial creditors, the study’s authors said three main insights emerged.

First, the Chinese contracts contain unusual confidentiality clauses that bar borrowers from revealing the terms or even the existence of the debt. Second, Chinese lenders seek an advantage over other creditors, using collateral arrangements such as lender-controlled revenue accounts and promises to keep the debt out of collective restructuring (“no Paris Club” clauses). Third, cancellation, acceleration, and stabilisation clauses in Chinese contracts potentially allow the lenders to influence debtors’ domestic and foreign policies.

“Even if these terms were unenforceable in court, the mix of confidentiality, seniority, and policy influence could limit the sovereign debtor’s crisis management options and complicate debt renegotiation. Overall, the contracts use creative design to manage credit risks and overcome enforcement hurdles, presenting China as a muscular and commercially-savvy lender to the developing world,” the report’s authors concluded.

Since Zambia will be the first nation with outstanding Eurobonds to use the new Common Framework, the outcome of talks with its creditors will be seen as a crucial test case for others such as Chad and Ethiopia, which have applied to use the same mechanism to restructure debt.

A committee of official bilateral creditors was due to be formed in March, with the aim of concluding financing assurances under the IMF-funded programme.

By the end of the June, proposals are expected to be presented to the IMF board. That would pave the way for a full debt-sustainability analysis and debt restructuring with all creditors, including Eurobond holders. But much will depend on the negotiating strategy Beijing and its lenders adopt.

While the Common Framework’s objective to treat all creditors equally can be met in different ways – by extending maturities, reducing interest rates or haircuts, or a combination thereof – China’s historical preference for maturity extension, over haircuts and lower interest costs, threatens to complicate negotiations. There is also some concern China is labelling debt as commercial, rather than bi-lateral, to reduce the proportion of debt re-negotiated under the Common Framework.

Then again, while China could choose to charter its own course unilaterally, there are good reasons why it may want to participate in collective debt forgiveness with multilateral institutions and other lenders, thereby avoiding the bun fight that might otherwise ensue. The same goes for the debtor nations themselves.

Investors should pay close attention

Nonetheless, it is more important than ever for investors to understand the composition of government debt, not just headline levels, to gauge potential restructuring terms and recovery values. For Zambia to get on a more sustainable fiscal path, we estimate all debt holders will need to take a haircut of around 20 per cent. The fact Zambian debt is currently pricing in more than this reflects uncertainty as to the outcome of the negotiations.

In Ethiopia, another country that has asked to restructure debt under the Common Framework, progress has been extremely slow. The country might opt to follow Angola’s example, and seek to renegotiate debt with China, on a bi-lateral basis, outside of the framework, as a stop-gap measure.

Since Ethiopia has a liquidity problem but not a solvency issue, were it to do so, this could be good news, paradoxically, for bondholders. That said, the ongoing war in the country remains a cause for concern.

The outcome of Zambia’s negotiations could even provide valuable insight into what happens in countries such as Sri Lanka that opt to restructure debt outside the Common Framework. Both Eurobond investors and Chinese lenders have sizeable exposure to Sri Lanka. The bond market is currently signalling recovery values of no more than 50 per cent. That would imply some upside for bondholders, but only so long as China is willing to shoulder an equal share of the burden.