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«2015 Bilateral debt Multilateral 8000 7000 poverty 6000 goals 5000 sustainability 4000 3000 macroeconomic millennium 2000 1000 0 1995 1996 1997 1998 ...»

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On the other hand, though the non-bank sector is seen to be the biggest holder of debt, often this segment is probably not a willing party to being a domestic debt creditor.

As highlighted above, the government is able to “borrow” from the non-bank sector by simply delaying payments to retirees, retrenched persons, goods and services providers, and other such economic agents to which government can make deferred payment.

4.4 Benefits of Frontloading, and Cost Implications of Domestic Debt In the dominant economic policy generally ascribed to theories of Keynesian economics,

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there is tolerance for fairly high levels of public debt to pay for public investment in lean times, which can be paid back with tax revenues that rise in the boom times. Through the proliferation of this theory in the 1930s globally, many nations took on public debt to finance large infrastructure capital projects such as highways or large hydroelectric dams. The thinking was that this would initiate a virtuous cycle and a rising business confidence since there would be more workers with money to spend.

Benefits of Frontloading Given the financing gaps entailed by the current design of national developmental programs and anticipated difficulties in future financing (e.g., limited concessional external borrowing, uncertain ODA inflows, limited tax revenue avenues domestically, etc) as 4 Zambia strives to implement the FNDP and ultimately achieve the MDGs, it is fairly obvious to see why Keynesian-type economics focused on domestic borrowing may be politically attractive. Taking on more debt would allow the frontloading of targeted public investment in key areas.

Following along similar lines of argument, Roy et al (2006) assert that although there is inconclusive evidence on whether or not public investment in infrastructure has a significant positive impact on growth, there is a strong consensus on the positive effect of infrastructure investment on productivity and output in different regional and sectoral settings. This suggests that “well designed public investments, including infrastructure, do have a direct positive impact on the MDGs”[p.i].

Based on such Keynesian-type economic principles, many observers therefore argue that the benefits of frontloading certain priority development investments in terms of the associated potential for making faster strides towards meeting developmental goals within set timelines justifies taking on more domestic debt (see, Weeks and McKinley, 2006; Christensen, 2004, Adam et al, 1999).

Domestic Debt Service Cost Issues A key concern regarding domestic debt management is the cost, in terms of interest payments to the budget. Domestic interest payments are sizeable compared with revenues and GDP.

Over 1996-2005, average interest payments on domestic debt as a percent of revenues have been fitful with some significant and alarming increase in some periods (see Figure 4.6). And as interest repayments on external debt continue their HIPC-aided downward trend, it seems likely that the domestic interest repayments burden will become more severe. In 2005, domestic interest payments increased sharply to almost 10 percent of Zambia’s revenue.

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% 6 4 2 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 4 It is quite clear that domestic debt has fast become a significant problem in Zambia because while both the domestic debt stock (relative to GDP and revenue) and real interest rates are declining, a significant repayment burden still remains. Moreover, the country’s ambitions to address its Millennium human development challenges mean that new pressures to generate finance for its FNDP programs are only just beginning to mount. This is a strong likelihood of future domestic borrowing and an increase domestic debt stock. For example, it has been reported that although the servicing cost of domestic debt has started to decline recently due to lower real interest rates, the volume of government issued securities is still rising.

Notwithstanding the growth and poverty reduction benefits that can be realized from the targeted use of government borrowing, Zambia also remains vulnerable to interest rate rises which would significantly increase the cost of servicing its internal debt. A rapid sensitivity analysis of domestic debt payment obligation to real interest rate changes (i.e., changes in the difference between the interest rate and the inflation rate) shows that service costs are very sensitive to real interest rates (Table 4.2).

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Notes and Assumptions:

The real interest rate (real WATBR) is used as the proxy rate of domestic debt service, worked out as WATBR – Overall period average inflation.

The first two data columns (Scenarios 1 & 2) are based on actual historic data, with no projections. The last three columns (Scenarios 3, 4 and 5) are projections based on different assumptions about inflation and nominal interest rate outturns.

Moderate inflation is defined as 15%, which is the end-year 2005 period figure Low inflation is defined as 9 percent, which is among the lowest inflation rates that the Zambian economy has achieved in over three decades.

The real interest rate projections: in Scenario 2 assume 2001-2005 interest rates with 2005 inflation; in Scenario 3 assume 2001-2005 interest rates with low inflation; and in Scenario 4 assumes 2005 interest rates with low inflation.





Source: Author’s construction using BOZ and MOFNP data As would be expected, with high real interest rates (e.g., Scenarios 1 and 4), the domestic

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debt interest payments (both as a percentage of GDP and fiscal revenue) would be very high. The opposite is equally true of low real interest rates (see Scenarios 2, 3 and 5).

Scenario 4 highlights some important underpinnings about the potential service costs on domestic debt. If nominal interest rates should rise while inflation is kept at the current low levels, the real interest payment obligations would increase considerably to

2.8 percent of GDP and 11.3 percent of fiscal revenue.

Such payment obligations would further squeeze out priority investment in areas such as those identified in Zambia’s FNDP. The considerable sensitivity of the domestic debt repayment costs to changes in the real interest rate is therefore well illustrated in the above table. It demonstrates that low inflation targets should be coupled with low interest rate targets. A situation that combines low inflation with relatively high interest 4 rates (e.g., Scenario 4) would potentially bring significant domestic debt service costs to bear on the economy. Inflation movements and changes in the nominal interest rate readily translate into sizable domestic debt interest repayment movement, as a share of both GDP and fiscal revenue. In that regard, an important policy message is that strategies and policies for inflation management should be applied in tandem with measures for lowering interest rates on borrowing as well as managing the spread between lending and saving rates. Such measures have the potential to save substantial amounts of funds by averting some of the costs of domestic debt service.

The significant domestic debt problem, particularly the potential for incurring a huge repayment burden, raises concern about fiscal sustainability. Some observers have suggested that in the worst case, this problem may call for further reaching reforms on the domestic front. One option would be to pursue debt reduction schemes for domestic debt similar to the HIPC Initiative. Many have cautioned however that an outright reduction in domestic debt could increase the liquidity in the system and thereby endanger macroeconomic stability.

Another suggestion found in the literature (Weeks and McKinley, 2006; Christensen, 2004, Adam et al, 1999) is for the Zambian authorities to restructure domestic debt by extending the maturity structure of the debt. Alternative restructuring options have been suggested by the various commentators. These recommendations are against the background that Zambia’s past debt markets have tended to be of short duration (273 day maximum on Treasury bills and 24 month maximum duration on bonds) (see, Table 4.1). The restructuring of government’s domestic debt owed to the Bank of Zambia into a 10-year bond in 2004 is perhaps a step in the right direction31.

4.5 Domestic Resource Mobilization in Zambia As has been discussed in a number of earlier parts of the paper, the scope for generating additional domestic revenue is currently relatively constrained. With a narrow tax base, 31 That is, assuming that Christensen’s prescription is correct.

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a regressive tax structure, low tax efficiency, and tax buoyancy that has reached its limit under the current circumstances, tax performance has stagnated below levels necessary for financing forthcoming development programs in the FNDP. Other (non-tax) revenue options do not contribute significantly to domestic revenue.

Some commentators have recommended taking on more debt while ensuring to restructure the domestic debt market. Although some of the specific suggestions for the restructuring have been debated and criticized, the fact is increased domestic borrowing with debt restructuring is a possible source of additional domestic resources.

On the other hand, many commentators argue that there is significant scope to reallocate resources toward priority (more pro-poor) sectors within the existing budget.

For instance, officials in the Ministry of Finance indicated that there is significant room 4 within the current wage bill ceiling (of 8.1 percent of GDP) to down-size some less priority areas and increase spending in priority health, education and growth sectors.

Similarly Weeks and McKinley (2006) argue that there is scope of up to 3.3 percent of GDP to switch expenditure from General Public Services, Defense and Public Safety to priority areas for poverty reduction and meeting the MDGs.

Unfortunately, the political choices of the country in terms of budgetary allocation do not always reflect the priority pro-poor spending allocations required in various development plans (FNPD, PRSP, TNDP). There seems to be little real political will to realize pro-poor allocations within the budget unless external impetuses are exerted (the example was earlier given about how priority poverty reduction spending in health sometimes has to be forced (see Figures 1.2 and 1.3 presented earlier)).

It will be critical in Zambia’s development and poverty reduction process for the authorities to muster the political will to make hard choices that shift resources to priority poverty reduction spending. In this regard, it will be important to improve the integration of the MTEF framework with the National Development Plan (NDP) and sectoral plans. Given that the NDP and sectoral plans are a closer reflection of the true costs of development and meeting the MDGs, the national financing framework – the MFET – should be the one to respond to the requirements of these plans, not the other way round. In this sense, even in the circumstance of constrained availability of additional domestic resources, political choices will be based on pro-poor and MDGsconsistent plans which will foster appropriate allocation of national resource to priority poverty alleviation areas.

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5 Future Financing and Debt Sustainability in Zambia

5.1 On Future Debt in Zambia: National Authority and Creditor Views In Section 4.2, two important issues were raised; (a) about Zambia’s prospect for future borrowing and on what terms (i.e., from concessional and non-concessional sources);

and (b) about how much more/less borrowing space the country might realize (on both concessional and non-concessional arrangements) and for how long. These two aspects are considered in more detail in this section.

Firstly, how much debt will Zambia be able to successfully negotiate for as concessional borrowing? The answer to this question depends on the agency that one considers.

For instance, in the FNDP the MOFNP has indicated that external loans will average

1.0 percent of GDP or US$ 160 million per annum, inclusive of already existing loans that are programmed to be disbursed over the implementation period of the FNDP.

New external borrowing is expected to be in the region of US$ 50 to 60 million per year, mostly in the form of concessional loans from the World Bank and the ADB. Beyond the time horizon of the FNPD (i.e., 2006-2010), the outlook on further concessional borrowing is not clear.

On the other hand, according to the IMF, new external borrowing by the Zambian government will be required to remain in line with trends that form the basis of projections in the 3-year PRGF-supported program, partly reflecting a shift to greater donor assistance in the form of grants (ODA). Thus, new external borrowing, excluding IMF disbursements, is assumed to be about US$120 million a year over the medium term, mostly from IDA and the African Development Bank. This figure would fall to US$105 million in 2009, as a greater share of donor assistance comes in the form of grants.

From this level, new external borrowing will remain constant in real terms from 2010 onwards.

According to the Ministry of Finance (MOFNP 2004c), the bilateral partners perform better than the multilaterals on “condition precedent” in that they have fewer conditions which are less difficult to comply with. Thus, as a strategy, the authorities declared that “it is recommended that countries like China and Belgium be pursued for assistance as they have proved to be non-conditional in their deliverance of aid”. In this regard, in August 2007, the Chinese government approved a US$39 million loan to Zambia for infrastructure development, mainly road construction (see also, MOFNP ranking or Donors/Creditors in Table 5.1 below).

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Source: MOFNP (2004c) Comparing the perspective of creditors (signaled by IMF views and assumptions) with that of the national authorities, it is clear to see that in principle the government is willing to take on only 42 to 50 percent of the concessional borrowing that has been indicated as available to Zambia by donors.



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