Zambia’s default and its prospects for recovery

Zambia’s finance minister has confirmed that the country will default on US$3bn of hard currency bonds¹, following more than a month of negotiations between the Zambian government and the Zambia External Bondholder Committee (ZEBC), with Zambia requesting consent solicitation to pause eurobond coupon payments for six months. The consent solicitation was widely rejected by bondholders, for reasons we will expand on below, and the decision left the Zambian government with the choice of withdrawing the consent solicitation and paying out the US$42.5mn coupon², or defaulting. A statement by the minister of finance³ after the result of the consent solicitation indicated the government has chosen the latter option stating issues related to existing external arrears as the main determinant of the choice to default.

This default represents the first African default to take place during the COVID-19 era and while the pandemic accelerated the government’s need to make tough decisions, the root causes for its credit problems lay elsewhere, in our view.  We trace the country’s difficulties to large scale externally financed infrastructure investments done under auspices of economic development, but in the end resulted in a significant misallocation of capital. The Link Zambia 8000 project, for example, aims to transform Zambia from a land-locked to a land-linked country by paving 8,201km of road across the country at an estimated cost of US$5.3bn⁴. Combined with expenditure on a range of other projects including power generation, expanding the rail network, and improving the roads around Lusaka, Zambia’s external debt/GDP ratio has risen from 32.8% in 2015 to almost 80% by 2020. Although investors recognise the importance of infrastructure investment in a landlocked country such as Zambia to act as a springboard for future growth, the case of infrastructure investment in Zambia had 3 serious shortcomings which contributed to increased credit vulnerability:

1. Loans were signed onto without any consideration for the country’s short and medium-term debt carrying capacity, resulting in a significant pipeline of committed loans
2. Some loans reflected political rather than economic considerations, which was driven by a fractured political landscape which followed the death of the previous president, Michael Sata
3. Often these infrastructure loans had aggressive amortising structures, resulting in a drain on the country’s scarce foreign reserves, which resulted in continued currency weakness

The effects of all this expenditure have so far proved disappointing, with Zambia’s annual GDP growth since the programme started in 2016 averaging 3.2%, compared with an average 7.4% for the 10 years previously. Over the past five years, the Zambian kwacha has lost 80% of its value against the US dollar. With pressure building and financing options limited, COVID was a likely final catalyst driving September’s request by the government to seek the six-month debt moratorium.

The ZEBC had been clear from the outset that if it were to agree to any payment delay, two requirements would be necessary:

• There had to be a clear view on the medium term economic framework for the country and given the country’s recent economic track record this programme would preferably have the backing of an institution such as the IMF
• There would need to be inter-creditor equity in the restructuring effort with all commercial lenders treated on similar terms. This needs to be done to ensure that debt service relief from any party not used to pay another. This was an important issue for eurobond holders, who comprised one-third of the total debt stock but were a much smaller component of the country’s short term external debt, whose servicing had been such a drain on the country’s reserves

We expect discussions between bondholders and the Zambian government to continue ahead of the next coupon date of 30 January 2021, with the IMF mission in December 2020 another important date to monitor.

Even though negotiations could still take time, we remain long Zambia’s hard currency bonds, which we built-up at depressed prices. Our view of recovery has always been on the understanding that even though a restructuring is necessary, the conditions under which this could take place and the size and type of adjustment that will be required means that investors would be rewarded for taking a longer term perspective.

The reasons for our more sanguine view on recovery relative to current prices are two-fold:

1. Size and structure of adjustment required to bring down debt to GDP
   
   

   a) As already highlighted, it has been Zambia’s excessive spending on infrastructure that has pushed the country’s debt into unsustainable territory. This is important because although any reduction in expenditure will require decisive leadership, history has shown that the adjustment of capital vs current spending is easier from a socio-political and implementation level than it is to remove subsidies or cut government workforce

   b) Assuming no meaningful effort on revenues or other expenditures, a return of capital expenditure to pre-2015 averages would imply a 4% adjustment to primary balances resulting in a 4% of GDP primary surplus, which is in line with the latest World Economic Outlook from the IMF. This would be sufficient to place debt to GDP on a declining and sustainable path

2. Progress on external rebalancing
   
   

   a) Progress on external rebalancing is already very far advanced. Zambia has a fully floating exchange rate, distinguishing it from other recent defaulters such as Argentina, Ecuador and Lebanon, and the decline of the kwacha has already meaningfully adjusted to underlying economic realities

   b) The current real effective exchange rate is at its weakest level since 2004 and the continued improvement in Zambia’s external balances, helped by the weaker currency and higher copper prices, means the country is now running a 9.5% of GDP trade surplus, its largest level in almost 10 years. Assuming that Zambia is finally dealing with its infrastructure loans, we would expect results similar to what occurred in 2004, when after a period of significant economic stress, relief on debt payments under the Heavily Indebted Poor Country initiative resulted in a 25% rally in the kwacha over the following 3 years. A stabilisation of the kwacha would be an essential component in the country’s return to macro-economic and debt stabilisation, and in our view this process is now underway

The road could still be windy, but in our view a process has been set into action through which Zambia can set a course back towards macro-economic stability.

¹ All sources are from Bloomberg as at November 2020, unless stated otherwise.
² Zambia on brink of default after lenders reject debt relief request, Financial Times, 13/11/20.
³ Zambia will miss Eurobond payment, setting stage for default.
⁴ US$5.3bn Link Zambia 8000 road project is creating demand for earth moving equipment, Construction Review Online, 9/11/15.