Challenges to debt sustainability and financial market development posed by COVID-19 and the war in Ukraine

While chronic fiscal and current account imbalances that arose well before the Covid-19 pandemic placed limits on the ability of country authorities to respond to unexpected shocks, this did not prevent authorities in four of the focus countries

– Ethiopia, Ghana, Kenya, and South Africa – from adopting counter-cyclical fiscal measures that led to the accumulation of high levels of public debt.

This study shows that while all countries are exposed to liquidity and solvency risks, the most important risk to be monitored is the risk of an external debt distress. Ethiopia, Ghana, Kenya, and Nigeria face high levels of liquidity risk associated with their external indebtedness, and the risk of debt distress during the next decade in Ethiopia, Ghana, and Kenya is considered high. The availability of foreign exchange required to fund the current account deficit and external debt service is constrained by low public revenues (Ethiopia, Ghana, and Nigeria) and large trade deficits (Ethiopia, Kenya). At the same time, prospects for alleviating liquidity pressures in the short to medium term are limited, as they depend on structural changes aimed at reducing current account deficits. Indeed, it is anticipated that these pressures will become even more acute in 2022/2023 due to a combination of three factors – historically high levels of public debt, rising market interest rates and downward pressure on many emerging market currencies – which have caused the cost of external borrowing on commercial terms to become prohibitive.

Prior to the pandemic, given the limited depth of their financial systems, Ethiopia, Ghana, and Kenya had already accumulated unsustainable levels of public debt. Computational simulations

show that over the coming decade the level of public debt to GDP in Ghana, Kenya, Nigeria, and South Africa will stabilise, although in Ghana, Kenya, and South Africa this will happen at historically high levels, resulting in high debt service burdens and constraining fiscal space for new public investments. An important lesson highlighted by Covid-19 and the Ukraine war is the extent to which debt vulnerability derives from exposure to external creditors both in terms of the ability of sovereign borrowers to honor their external debt service obligations, and in terms of high debt service obligations which can lower economic growth prospects in the medium to longer term.

A comparative analysis shows that Nigeria and South Africa, Sub-Saharan Africa’s two largest economies, are in a less precarious situation than the other three countries. Nigeria entered the Covid-19 crisis with a lower level of public debt while South Africa’s deep domestic financial market makes it possible to absorb higher levels of public debt.

However, Nigeria and South Africa need to address specific risk exposures. Due to low fiscal revenue mobilisation, Nigeria’s total debt service absorbs a high share of government revenues, thus exposing the government to liquidity risk. Even with its more developed taxation system, South Africa is also exposed to liquidity risk because the ratio of total debt service to revenues is high. While foreign investors impose discipline on macroeconomic management, which should ultimately benefit the South African economy, reliance on foreign portfolio investment in domestic government debt exposes South Africa to risk, due to the ‘vagaries’ of foreign portfolio investors.