Government bonds: catastrophic behemoths in the financial sector

Government bonds: catastrophic behemoths in the financial sector

Risk-Free Investments, Uncertain Fate

It's a common belief that the builders of the Titanic thought nothing could sink the ship—except maybe the Almighty. In the world of banking and finance, government securities are often seen as the Titanic, supposedly immune to failure. These securities are considered low-risk because they're backed by the government, making default incredibly uncommon. Or so we thought.

In Ghana, the myth of risk-free government securities was shattered when the government defaulted on its bond payments through restructuring and reissuing new bonds. This left banks and other investors who had heavily bet on these securities struggling with significant losses and survival issues.

2020: Year of (apparent) safety

During the height of the COVID-19 pandemic in 2020, it was quite unusual to see the banks reporting impressive profits. Most industries were struggling due to lockdowns and production drops, leaving them with little need for working capital. These funds were left with the banks, which were more than happy to park them in government securities.

Being an election year and with COVID-19 serving as a convenient excuse, the government had enough reason to borrow and splurge. So, the banking industry invested heavily in government securities, raking in profits throughout 2020. It seemed that government securities were truly risk-free, as the government honored all coupon and principal payments despite the pandemic's negative effects.

2022: The government's gamble

It's puzzling why a government that didn't default on debt obligations during the pandemic would do so just two years later. The key lies in understanding the concept of government securities being risk-free. Governments typically finance their debts through tax revenues. However, when revenue isn't sufficient to cover debt obligations, they have two main options:

1. Printing money through the central bank, but this isn't wise during periods of high inflation.
2. Taking on new debts to pay off the old ones. This leaves the government at the mercy of the market—if the market refuses to provide funds, default becomes inevitable.

Foreign currency-denominated debts are best resolved using the second option because governments can't print foreign currency. But in 2022, with a high inflation rate, printing money wasn't advisable, so the second option became the only option. The government had planned to borrow on the market, particularly for foreign currency-denominated debts. However, the country's credit rating was downgraded, and major economies increased interest rates, making them more attractive to investors, making borrowing difficult.

As a result, the International Monetary Fund (IMF) stepped in as the lender of last resort.

DDE programme: The tough pill to swallow

When lenders extend credit, they want assurance that they'll be repaid. This is true for individuals as well as international organizations like the IMF. When assessing Ghana's ability to repay its loan, the IMF found that the government was already heavily indebted. So, Ghana undertook the Debt Exchange Programme (DDE) as a first step in reducing its existing debt obligations and increasing its revenue generation.

However, the banking industry and other investors are feeling the impact of the steps the government is taking to manage its debt obligations.

Deja vu: Back to the drawing board

In 2001, Ghana applied for HIPC relief due to debt sustainability issues. Fast forward 20 years, and Ghana is seeking debt relief again due to the same issues. The Finance Ministry blames COVID-19, Russia's invasion of Ukraine, and global monetary policy tightening for the current situation. But the problem with this line of thinking is that we'll continue to face the same challenges if we don't make significant changes to our economic policies and industry regulations.

Ghana's oil discoveries in 2000 and growth in several industries post-HIPC gave us a false sense of security. It's time for a comprehensive review of our economic policies and industry regulations to determine how to avoid these economic pitfalls in the future. We must implement stricter checks and balances on the government's financial behavior, particularly regarding foreign currency-denominated borrowing. Proper policies and strategies need to be developed for borrowing and repayment instead of the usual borrow-to-pay strategy.

Ostrich defense: The politics of public debt management

The DDE programme was delayed by two years because the ideal period for the government to have restructured its debt was during the peak of the COVID-19 pandemic. The government, using the pandemic as its main excuse, took on new debts to pay off old debts, all while maintaining an air of financial stability. The government's unwillingness to be upfront about Ghana's financial problems undermines citizen trust and Patriotism. Honesty about the financial issues and taking immediate action to rectify them would inspire citizens to support the government in restoring the country's financial health.

Private sector: The industry's supercar

In Africa, the public sector is often plagued by corruption and bureaucracy, making it inefficient. The private sector, on the other hand, is considered efficient, thanks to competition and profit motives. Although both sectors play an essential role in economic development, the private sector is seen by most economists as the primary engine for economic growth and development.

However, the recent impact of the DDE program on the banking industry suggests that banks invest most of their funds in the government rather than the private sector. It makes sense for banks to invest in the relative certainty (low-risk) of government securities instead of gambling on the private sector.

The private sector can be highly rewarding for banks if they invest in business development teams trained in evaluating businesses to identify start-ups and small and medium-scale enterprises with growth potential. These businesses can grow into cash cows for the banking industry and drivers of economic growth for the country. But banks are reluctant to lend to these enterprises because they perceive the investment as risky, preferring to focus on established, low-risk ventures.

It's worth noting that taking risks sometimes leads to greatness, as Ferruccio Lamborghini once said, "What better way is there to do it than in search of greatness?" So, let's take a chance on the private sector for the greater good of our economy and country.

The author is an MPhil Finance graduate of the University of Ghana Business School and a member of the Institute of Chartered Accountants, Ghana.

Insights:

• When a government's debt is perceived as unsustainable, it can deter banks from investing in government securities, leading to lower investments and potentially negatively impacting the banking sector's overall stability and performance.
• In situations where the government's debt is considered risky, yields on government securities may rise to compensate for the increased risk, potentially improving investor returns but also indicating a higher cost of borrowing for the government.
• Fiscal discipline on the part of the government, such as spending controls and efforts to achieve a primary surplus, can stabilize the financial environment, making government securities more attractive to banks, thereby improving investor confidence and enhancing economic growth.

1. In Ghana's banking and finance sector, government securities, once seen as risk-free, were exposed as potentially volatile due to the government's default through restructuring and reissuing new bonds.
2. During the height of the COVID-19 pandemic in 2020, banks reported impressive profits seemingly due to their investments in government securities, but this apparent safety was deceiving.
3. In 2022, the government's inability to borrow on the market due to a downgraded credit rating and increased interest rates led to a default, revealing that government securities are not entirely risk-free.
4. The International Monetary Fund (IMF) stepped in as the lender of last resort when the government's borrowing difficulties made it impossible to honor debt obligations.
5. Ghana's ongoing struggle with debt sustainability necessitates a comprehensive review of economic policies and industry regulations, emphasizing stricter checks and balances on the government's financial behavior, particularly regarding foreign currency-denominated borrowing.
6. Banks, preferring the certainty of government securities, have been reluctant to invest in the private sector, which has growth potential but is perceived as risky.
7. To achieve economic growth and development, banks should invest in business development teams trained to evaluate potential start-ups and small and medium-scale enterprises, which can grow into cash cows and drivers of economic growth, despite their perceived risks.

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