The Tale of Two Deleveragings
How the Bank of Ghana is putting Godwin Emefiele to shame
Generally, I wouldn’t say I like bonds. I like to think of myself as an optimist, and ‘optimistic bond investor’ is a bit of an oxymoron. When you buy a bond, your upside is (mostly) fixed, and you can only focus on and try to limit the downside, so skeptics rather than optimists rule in that world. However, I have been paying a lot more attention to bond markets this year because interest rates are rising worldwide, and bonds are the first market to react to interest rate changes. A market is nothing more than a system that conveys information using prices, so it’s an excellent framework for me to learn about what’s happening in the world.
Ghanaian Eurobond prices have fallen nearly 50% this year, pushing the implied yield to almost 30% in USD. Naturally, this piqued my interest (and greed), so I decided to dig into what information these prices were trying to convey. When a country’s bond prices fall so dramatically, it’s likely because investors are skeptical that they will get their money back, and so they sell now to cut their losses. So the market believes that Ghana is likely facing a debt crisis. For investors to accept only half their money now indicates that they think something terrible is happening.
Given that Nigeria is facing its own fiscal crisis, I was curious to compare how Ghana is handling their crisis compared to Nigeria and how that will affect its ability to pay back and, subsequently, the value of the securities. As I will explain in the rest of this article, it appears that the Ghanaian government and the Bank of Ghana are engineering a beautiful deleveraging; meanwhile, Godwin Emefiele is sending Nigeria down a hyperinflationary spiral.
Ghana, like Nigeria, has found itself in this position because of a lack of fiscal discipline, running large budget deficits that spurred a dependency on cheap USD loans (mainly Eurobonds). As interest rates began rising, it became too expensive for the Nigerian and Ghanaian governments to borrow money from the international markets. The issue is further compounded by rising commodity prices, causing expenses to rise while incomes are falling simultaneously. This dynamic creates a gap between the amount of money coming in and the amount of money being spent that the countries must find a way to close.
Balance of payments crises can be analogous to a family or individual facing financial difficulties. If a family’s breadwinner loses their job and has to take a pay cut or faces a significant increase in costs, perhaps due to an illness, it would have a devastating economic effect on the family. To fill the gap between earnings and income, they will either have to reduce their living standards or become heavily indebted - if they can even access the capital. Countries, unlike individuals, have a few more options to deal with such crises. However, with no source of foreign capital, the governments had no choice but to resort to borrowing and printing local currency to buy dollars, devaluing their respective currencies and spiking inflation (~30% in Ghana and 20% in Nigeria) as imports became more expensive.
How countries close this gap between money coming in and money being spent ultimately determines how severe the inflationary deleveraging and currency crisis will be. A deleveraging is a difficult and painful situation, but handling a difficult situation in the best possible way is beautiful. The key to a beautiful deleveraging is balancing all the tools available to close the gap. Countries can achieve the right mix of cutting spending, reducing debt, printing money and redistributing wealth to ease some of the pain.
Ghana, unlike Nigeria, quickly limited their money printing to stay within its legal limits because they understand the long-term effects of money printing. Quite frankly, this alone already constitutes significantly better handling of the crisis - orders of magnitude better. This is because continually printing money to finance external spending has been the cause of every hyperinflation in history. While in some cases, its involuntary, in Nigeria’s case, it is 100% a policy choice.
Even though the Ghanaian Cedi has fallen nearly 40% this year, they are managing their currency much better. Letting the currency decline so quickly in such a big way means that there is still a two-way market for the Cedi, i.e. people are not only selling the currency. The use of monetary policy here is also instrumental in making people willing to hold the currency. The Bank of Ghana jacked up interest rates to 22%, partially compensating people for the risk of devaluation if they hold cedis.
While many will correctly argue that such high interest rates will crash the domestic economy, that is the more favorable result because contracting domestic demand will bring down spending more in line with incomes. On the other hand, the Godwin Emefiele-led CBN has been running (relatively) loose monetary policy, keeping debt-fueled consumption high and putting off domestic pain but further spiking inflation. To continue with the analogy, it is like a family facing economic hardship borrowing money to maintain their standard of living instead of tightening their belts and making cuts where possible and borrowing only for essential, unavoidable expenses. They are merely prolonging and worsening the pain by trying to keep the same standards.
So, everything said and done, can Ghana afford to pay back their loans? And therefore have their bonds been priced too harshly? I would venture to say yes for quite a few reasons. The most important thing to determine is the risk of permanent capital loss. A disorderly default seems unlikely because the future costs of such a default, in higher interest rates and being cut off from international lending markets, are intolerable for most governments.
Given how they have handled their crisis so far, I find it hard to believe they would go down that path. They have also received $750m in financing from Afrexim bank and a $1bn syndicated cocoa loan to cover imminent maturities and hold the country over while negotiating a bailout from the IMF.
Despite this, some form of debt restructuring seems likely. However, the bonds are trading at 47 cents on the dollar, so even an egregious haircut of 40% would still put buyers of these assets firmly in the money, and investors get to have a say in the restructuring. Of course, this would make the bonds far less profitable.
Given that this is public information and shared knowledge for sophisticated investors, one might wonder why the market would react so harshly. This is where the importance of analyzing who the key players in the market are and what their motivation is. For the most part, retail investors don’t get the opportunity to invest in Eurobonds because they are often issued with a minimum investment requirement of $200,000.
Consequently, the most important players in the market are large institutional investors like fixed income funds, many of whom have strict requirements on the types of securities they are allowed to invest in. As Ghana’s balance of payments worsened, its bonds were relegated to CCC- (Junk bond status) by the rating agencies, which meant that many of these large institutions could no longer hold these bonds. This immediately turns these investors into forced sellers, and if you buy something from someone who has no choice but to sell it often, you can get a fantastic deal.
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