Essays on Sovereign risk management in African economies

Abstract

This thesis investigates sovereign risk management in selected African economies. Recently, sovereign risk management practices have become a vital tool for attaining strategic debt benchmarks and are now an integral part of wider strategic sovereign debt management policies. The primary objective of sovereign debt management is to minimise the long-term cost of borrowing at a given level of risk. These strategic cost-risk objectives constitute the basis of the standard micro-portfolio theory to sovereign debt management. According to the principles of portfolio theory, this cost-risk trade-off requires the use of a wider cost concept and the associated borrowing requirements. From a portfolio perspective, the sovereign asset and liability management (SALM) approach may detect the sovereign risks in the sovereign balance sheet. Therefore, the sovereign debt crisis of 1980s, which was preceded by a high level of sovereign risks, has triggered a growing debate on the need for sound sovereign risk management in developing countries.

The persistent high level of sovereign risk in highly indebted poor countries is attributed to the tendency of borrowing abroad in foreign currency and servicing the debt using the government tax revenue, which is in local currency. In turn, this creates a currency mismatch when the exchange rate depreciates in a country with floating exchange rate regime. An increase in currency mismatch leads to debt accumulation and consequently, may raise the probability of a sovereign debt crisis. Sovereign debt crisis occurs when a country fails to pay the interest rate on its debt obligations because it is either illiquid or insolvent. In theory, it is suggested that the currency mismatch can be offset by matching the currency composition of foreign liabilities and the currency composition of foreign reserves. In addition, several studies highlight that the currency composition of foreign debt can be used as a perfect natural hedge to adverse exogenous shocks, in particular, the exchange rate shocks. Our study employs panel dynamic OLS and panel fixed effects to investigate the aspects of sovereign risk management in African countries. As a robustness check, we employ the seemingly unrelated regression model and the generalized method of moments with instrumental variables.

This study has three main contributions across the three aspects of sovereign risk management. The first aspect is the currency composition of foreign debt. The second aspect is the sovereign risk premium, which is the yield difference between the government bond and the 10-year US Treasury bond. The third aspect is a proposal for the use of alternative hedging instruments that can minimise the cost of debt and sovereign risks. The thesis has five chapters. Chapter 1 is the general introduction. Chapters 2, 3, and 4 are the main chapters on sovereign risk management. Chapter 5 concludes with policy recommendations and the suggestion for further areas of research. Chapter 2 investigates the currency composition of foreign debt in the selected African countries. I derive the foreign debt portfolio management model to determine the deviation of the debt portfolios from the optimality. In addition, I estimate our model using the panel dynamic Ordinary Least Squares. For robustness, I use the time-series Seemingly Unrelated Regression model for cross-country analysis. The findings show that the foreign debt management policies are suboptimal in hedging external shocks. Foreign currency debt shares are significantly affected by the cross-currency exchange rate movement in British Pound/US Dollar and Japanese Yen/US Dollar. The Swiss Francs/US Dollar exchange rate is insignificant. On the other hand, the trade patterns and the structure of the economy proxied by the manufacturing sector/GDP ratio are significant in affecting the optimality of foreign currency debt portfolios in the selected in African economies. A cross-country analysis is carried out using the time-series SUR model.

Chapter 3 investigates the determinants of the sovereign risk premium in African countries. We employ the dynamic fixed effects model to determine the key drivers of sovereign bond spreads. Country-specific effects are fixed and the inclusion of dummy variables using the Bai-Perron multiple structural break test is significant at 5% level. For robustness, the time-series generalized method of moments (GMM) is used where the null hypothesis of the Sargan Test of over-identifying restrictions (OIR) and the Arellano-Bond Test of no autocorrelation are not rejected. This implies that the instruments used are valid and relevant. In addition, there is no autocorrelation in the error terms. Our results show that the exchange rate, M2/GDP ratio and trade are insignificant; hence, they are dropped out. Furthermore, our findings indicate that public debt/GDP ratio; GDP growth; inflation rate; foreign exchange reserves; commodity price and market sentiment are significant at 5% and 10% level. However, the identified structural break dates are 1979 and 1980 which are attributed to the commodity price shocks. Meanwhile, the structural breaks in 2001 and 2002 are due to the commodity super cycles. The structural breaks in 2007 and 2008 are attributed to the global financial crisis of 2007.

Chapter 4 investigates instruments for financing economic development and hedging sovereign risks in African countries. We review the current risk management instruments that are used in sub-Saharan Africa and the current status quo of African financial markets, which will assist in designing appropriate hedging instruments. Furthermore, we propose alternative and innovative hedging instruments that can be used to minimise the cost of sovereign debt and hedge sovereign risks. Chapter 5 shows that these results have several important implications for policymakers in developing countries. From the risk management perspective, sovereign risk management should be based on the cost-risk criteria to hedge government’s budgetary risks from exogenous shocks. The other implication is that policymakers should avoid risky debt structures that could raise the likelihood of future sovereign defaults. Instead, they should adopt sound risk and debt management policies to prevent macroeconomic instabilities and consequently, sovereign debt crisis. Another implication is that strengthening of the domestic financial sector policies, such as stock market development, will deepen the small and illiquid local bond markets to enable borrowing in local currency and access alternative hedging instruments. Local currency borrowing reduces exposure to currency mismatches and currency risks. Furthermore, an important policy recommendation for African countries is the adoption of fixed exchange rate targeting to smooth out exchange rate shocks.