The impact of external debt on private investment in a low-income economy: the case of Sierra Leone

UNITED NATIONS NATIONS UNIES

AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENT AND PLANNING INSTITUT AFRICAIN DE DEVELOPPEMENT ECONOMIQUE ET DE PLANIFICATION

(IDEP)

THE IMPACT OF EXTERNAL DEBT ON

PRIVATE INVESTMENT IN A LOW-INCOME ECONOMY: THE CASE OF SIERRA LEONE

SAHR LAHAI JUSU

Submitted in Partial Fulfilment of the Requirements for the Award of the Degree of

Master of Arts in Economic Policy and Management at the African Institute for

Economic Development and Planning (IDEP), has been read and approved by:

ChiefSupervisor:

Thesis Committee: Members

Dr. Geoffrey N. MWAU

^

Dr. Philip K. QUARCOO

Dr. Karamoko KANE Dr. Hakim B. HAMMOUDA External Examiner:

Directorof IDEP: Dr. Jeggan C. SENGHi

DEDICATION

This thesis is dedicatedtomylateparents

and late brothers. Maytheir Souls Rest in Perfect Peace.

i

ACKNOWLEDGEMENTS

The successful completion of this thesis has not been without

the assistance of various

people and

institutions.

For

this

reason

I

see

myself

as

having done little

more

than

serve as an

agent for the consumption of

collective endeavour. But, since the final report

now

carries

my

name more conspicuously than other

contributors, I hereby confess publicly the efforts of all

those who shared inmy quotaofresponsibility. I am

grateful

to

these rescue-missioners, who

aremany.

Most important, I am indebted to my government,

through the ministry of Economic

Planning and Development, whose

authorities

gave me

the opportunity to undertake this

course. Yet, this attempt would have been unlikely

without the financial

support

by the

CommonwealthFund forTechnical Cooperation(CFTC). I amhighly

grateful

to

the personnel

oftheCommonwealth Secretariat.

I am very grateful to my committee

of supervisors, namely Dr. G. Mwau,

as

chief

supervisor, Dr. P.K. Quarcoo and Dr. K.

Kanè

^as

members and Dr. H. Flamounda

as

External

Examiner. I benefited a great deal from Dr. Mwau's

critical criticisms of

^my

initial uncertain

steps,incisive comments and understanding

commitment throughout this project. My gratitude

is eternal to him. As to Prof. Quarcoo, my Lecturer and

Chief of Training for IDEP, I

am

thankful forhis unflagging support to the realisation ofmy

goal. Prof. Kané's unassuming but

solidcommentshelpedtocalm frayednerves. I am

sincerely grateful

to my

External Examiner

forendeavouringto readthis documentamidsthis

official assignments.

Also, I acknowledge and appreciate the contribution

of the Director of IDEP and his

members of Staff in providing me the

appropriate environment

to

undertake the M.A

programme. In

particular, I

put on

record the

very

valuable assistance rendered by the Library,

Computer, Translation,

Finance and Administration sections of the Institute. I believe, the

staffs regular and prompt responses to my

calls helped

me

in difficult times, particularly the

period oftheMilitary-Junta

interregnum in Sierra Leone. I

am

grateful to them all.

Back home, my relatives showed a lot

of love and have continuously prayed for

my

success. As they congratulate me, I must say

thank

you

for helping to complete this

programme.

Also, the assistance rendered

to me

by the Amara, Saffa, Yoki, Bocakrie, Jambai,

Ahmed Banya and Tai-Affik families

helped

me

in

no

small

measures.

I

pray

that the

Almighty Godbless them all.

Some of

my

intimate friends

across

Sierra Leone and in Dakar

contributed in severalwaysto thecompletionofthis

thesis. In particular, Matilda

^gaveme

the

courage and confort during

the preparation of this thesis. I

am

grateful and highly indebted to

her. All _my other friends will,

hopefully, view this result

as a

joint prize. I

owe

you a lot of

gratitude.

Thisthesiswas completedbecause God hasbeen

behind it. My God loves

everyone

and

helps thosewho help

themselves. I lack the verbal wherewithal for

a

full expression of the dept

of_my appreciation, but I

submit this work to the Lord for God's blessings.

By mentioning all these

diverse contributory

sources,

I do not intend that my

benefactors should be held responsible forany

inadequacies that the thesis

may

suffer; I alone

assume fullresponsibility.

ABSTRACT

In this thesis, the main objective has been to examine

whether external debt has

any significant influence on private

investment in Sierra Leone from 1970-1995. In order to

achieve this goal, specific objectives were

investigated. These included the analyses of the

impact ofboth long-term and short-term

debt

on

private investment, and the effect of private

and official debt overhang. The investigation was

then carried

out

within

^a

theoretical

proposition of " the

debt overhang hypothesis of developing countries" postulated by Sachs

(1989). Sachs argued that

when

a

debt overhang exists, the proportion of future investment

returns subjectedto implicittax

would increase and investment will therefore decrease through

thedisincentive createdbysuch tax.

To appropriately determine

the effect of debt overhang

on

private investment in Sierra

Leone, Ordinary Least Square (OLS)

regression technique

was

explored to specify and

estimate private investment model. The

specification of the function

was

adapted from the

work of Greene and Villanueva (1991) and the array of

literature reviewed. The specified

model hasbeenused to determine the aggregateeffect of debt

overhang

on

private investment.

The measurementofdebt overhang involves two concepts: the debt

stock-GDP ratio, which is

referred to as "pure debt overhang",

and debt-service ratio also referred to

as a

liquidity

constraint ofa debtor country. In order to empirically

investigate the research problem, it

was hypothesised that: first debt overhang

has negatively affected private investment, and second,

the impact of official debt overhang ^on

private investment is negative and greater than the

effect ofprivate debt overhang. The effects of

other macroeconomic and policy variables

were brieflyexaminedin themodelin orderto

avoid mis-specification.

Based on time series data for theperiod 1970-1995, the

empirical results validate the

debt overhang hypothesis ^on private

investment in Sierra Leone. The results of the empirical

analysis show ^anegative

and

strong

impact

on

private investment. The effect of debt overhang

as estimatedby the magnitude

of the coefficient estimates of debt-GDP ratio and debt service

ratio proved to be the strongest

factor that explains the weak private investment in Sierra

Leone.

The study also revealed

that the effects of short- and long-term debt overhang

supported the

findings obtained in the aggregate model that debt overhang has a negatively

significant

impact

on

private investment in Sierra Leone. It further shows that the disincentive

effect causedby short-term

debt is

more

than that of long term debt overhang. In addition to

the above, the study shows that

official debt overhang negatively affects private investment. In

fact, the disincentive

effect of official debt overhang, as indicated by the magnitude of the

coefficient estimate is greater thanthe

disincentive effect of private debt overhang. In overall,

the main hypothesis was

empirically validated from

a

set of successful economic theory tests,

statisticaland diagnostictests.

The estimated coefficients of most

of the macroeconomic variables were consistent

with a priori

expectations of economic theory and they depict transactions that affect private

sectoractivities.Based^ontheabove

findings, debt management policies are recommended that

would alleviatethe debtsituationand hence

promote private investment.

v

TABLE OF

CONTENTS

DEDICATION

I

ACKNOWLEDGEMENTS

! II

ABSTRACT

IV

LIST OFTABLE SANDFIGURES

VIII

ABBREVIATION

IX

INTRODUCTIONAND STATEMENTOFPROBLEM

1

1.0 Background

l

1.1 Statement oftheResearchProblem

3

1.2 Objectives of theStudy

5

1.4 Hypotheses oftheStudy

7

1.5ScopeandLimitations ofthestudy

7

1.7ChapterOutline

11

CHAPTER2

12

TRENDS INEXTERNALDEBTACCUMULATIONAND

PRIVATE INVESTMENT IN SIERRA

LEONE

12

2.0 Preview

12

2.1 TheTrendsinEconomicPerformance(1970-1995)

12

2.2 TheExternalDebtAccumulation andItsBurden

16

2.2.1 TheMagnitudeandDescriptionofExternalDebt

Accumulation 16

2.2.2 TheTrendsinDebt ServiceBurden

20

2.3 PrivateSectorPerformanceandPolicyEnvironment

29

2.3.1 ThePerformanceofPrivateSector

29

2.3.2 PrivateSectorPolicy Environment

31

2.3.2.1MacroeconomicPolicy Environment

31

2.3.2.2Financial SectorEnvironment

33

2.3.2.3TheLegal Environment

35

CHAPTER3

38

LITERATUREREVIEW

38

3.0 Introduction

38

3.1 ReviewofTheoreticalLiterature

38

3.2 EmpiricalLiteratureReview

51

3.3 ResumeofLiteratureReview

68

CHAPTER4

71

MODELSPECIFICATIONANDEVALUATIONPROCEDUREOF

ECONOMETRIC RESULTS 71

4.0 Introduction

71

4.1 ModelSpecification

71

4.1.1 TotalDebtOverhangandPrivateInvestment(Model1)

72

4.1.2LongandShort-termDebtOverhang

and

Private

Investment(Model 2) 79

4.1.2.2ShortTermDebtOverhangand PrivateInvestment(Model 2b)

81

4.1.3OfficialDebtOverhangVs Private

Debt Overhang and Private Investment (Model 3) 82

4.2 The EvaluationProcedure ofEconometricResults

85

4.3 DefinitionsandMeasurementsofVariables

86

ÍStTTm

CHAPTER 5 90

RESULTSANDINTERPRETATIONS 90

5.0 Introduction 90

5.1 TotalDebtOverhangandPrivateInvestment(Model 1) 90

5.2 Long-andShort TermDebtandPrivateInvestment(Model2) 100

5.2.1Long TermDebtand Private Investment(Model 2a)

100

5.2.2Short-termDebtandPrivate investment(Model 2b) 104

5.3 Model3:OfficialandPrivateDebtOverhangandPrivateInvestment 108

5.3.1 Official Vs PrivateDebtstocks andPrivateInvestment(Model 3a)

108

5.3.2Official Vs PrivateDebt Serviceand Private Investment(Model3b)

112

CHAPTER6 116

SUMMARY OFTHESTUDYANDPOLICYRECOMMENDATIONS 116

6.0 Introduction 116

6.1 Summaryof theStudy 116

6.2 PolicyRecommendations 118

6.2.1 DebtManagementPolicies

119

ReductionofExternalDebtStock

119

FiscalPolicy MeasurestoIncreaseTax Revenue

120

EstablishmentofDebtand AidManagementUnit

121

HumanResourceCapacityBuilding

122

MacroeconomicandFinancialPolicyRecommendations 123

6.3Conclusion 126

ANNEX 127

Annex1:DiagnosticTests 127

Annex2: Data 130

BIBLIOGRAPHY 132

vii

LIST OF

TABLE S AND FIGURES

Page

Table 1: Macroeconomic Indicators

14

Table2: Total andComposition ofExternal Debtby Source

19

Table3: Derive IndicatorsofExternal DebtBurden

23

Table5: SustainabilityIndicatorsofExternal Debt

Burden 29

Table5.1a: EconometricResults of Modell

90

Table5.1b: ResultsofDiagnostic Tests ofModel 1

91

Table5.2a: ResultsofModel 2a

100

Table5.2b: Diagnostic TestsofModel2a

103

Table5.3a: Results ofModel 2b

104

Table5.3b: DiagnosticTestsofModel 2b

107

Table5.4a: ResultsofModel 3a

108

Table5.4b: Diagnostic TestsofModel 3 A

109

Table 5.5a: Results ofModel 3b

110

Table 5.5b: Diagnostic TestsofModel 3b

111

Figure 1: Trendsin Short-andLongTerm

Debt Stocks 17

Figure 2: PrivateInvestment-Debt

Ratio 22

Figure 3: Debt-GDP

Ratio

and

Private Investment-Debt Ratio 22

Figure3: Trends in

Sustainable Borrowing 26

ABBREVIATION

ADB African Development Bank

ADI AfricanDevelopment Indicators

BIS Bank ofInternationalSettlement BSL Bank ofSierra Leone

CPI ConsumerPriceIndex DOH DebtOverhang

GDP Gross Domestic Product GNP GrossNational Product

HIPCs HighlyIndebted Poor

Countries

ICOR Incremental Capital-OutputRatio

IMF InternationalMonetaryFund

LDCs ^LeastDevelopedCountries

OAU Organisation ofAfrican

Unity

OECD Organisationfor

Economic Cooperation and Development

SAP Structural Adjustment Programme

SILICs SeverelyIndebtedLow-income

Countries

SL Sierra Leone SSA Sub-SaharanAfrica S United StatesDollar

ix

CHAPTER 1

INTRODUCTION AND STATEMENT OF PROBLEM

1.0

Background

The external debt problem of

developing countries since the beginning of the early

1980s triggered ^an extraordinary

macroeconomic shock in world economic history. Following

the enormous rise in oilprices of1973/74,

oil

exporters

placed

a

larger part of the proceeds on

deposit for onward

lending

to

borrowers mainly in developing countries (Greene et al (1990)).

This created effective willingness on the part of

international banks

to

lend to borrowers and

thus, external debt of developing

countries tremendously increased during this period. The

second oilprice increase in 1979

worsened the crisis causing Mexico to default ^on substantial

short-term debtservicedue in 1982.

In Africa, especially in low-income

sub-Saharan Africa, the external debt problem has

been associated with constrained productive activities,

and/or economic growth since the late

1970sto 1980s. Theirdebtswere mainlycontracted onhighly

concessional

terms,

and owed to

multilateral agencies orrich-country governments

and yet, the debts remained well beyond the

countries' capacity to pay (Claessens,

et.al (1996)). If considered

on

absolute basis, sub-

Saharan Africa's debt would not be worrisome but

comparative analysis

on

liquidity and

solvencyindicatorsindicate

that this region's

case

is still

^more severe

than that of other regions

(ECA (1997).

The debt service ratio ofdeveloping countries as a

whole increased from 13 percent of

gross

national product (GNP) in 1980 to 18.3 percent in 1990, then, in 1995, it slightly

declined to 17 percent. The ratio

for Latin American countries gradually declined from 36.3

percent in 1980 to

24.4

percent

in 1990 and then, marginally increased to 26.1 percent in 1995

(Global Development

Finance, 1997

p

14

^-

49). In the case of sub- Saharan Africa, this ratio

changed from 9.6 percent

in 1980

to

15.5 percent in 1995. Though it is numerically low

relative to that ofother regions, Africa's

economic features cannot allow prompt contractual

debt service payments without

having negative impact

on

investment and consumption

expenditures. In

fact, debt-export ratios for 1980, 1990 and 1995, present a clearer picture

aboutthe severityofindebtedness

in sub-Saharan African. Debt-export ratio sharply rose from

91.7 percentin 1980to

238.9 percent in 1989 (an annual average change of about 160 percent),

and five years later, it increased to

241.7 percent (World Debt Tables (1996)). By and large,

these indicators suggest severe

constraints

on

effective economic management and growth in

these countries.

During the 1980s, indebted

developing countries witnessed

a

spectacular decrease in

investment (Cohen (1993)). Private

investment

as a

ratio of

gross

domestic product (GDP)

remained low in sub-Saharan low-income Africa

throughout the 1980s (see Miller and

Sumlinski (1994)). In view of the

fact that most of these countries experienced weak or

declining economic growth over the same

period, their experience with severe external debt

burdenhasbeen arguedas asignificant

predictor militating against productive investment.

1.1 Statement

of the Research Problem

The triggering of the debt

crisis in 1980s is alleged to have set off a period of

macroeconomic instabilityindeveloping

countries. On this note,

many

analysts have attributed

thecontraction incapital formationandpoor

economic performance in Africa to the debt crisis

(Iwayemi (1995)). In

the literature, this problem has been analysed in the context of debt

overhang and its

implications

^on

the economies of developing countries (Sachs (1989). The

debt overhang hypothesis focuses on

the adverse effects of external debt on investment and

hence its impact on growth

and development. According to Sachs (1989), when a debt

overhang exists, it acts

like

a

distortionary tax, with

a

corresponding dead-weight burden. This

burden acts through two main channels:

the impact of debt stock and debt service payments.

Since creditors are expected to

appropriate

some

of the benefits of future investment, any

activity that involves

incurring

costs

in the future in order to increase investment will be

discouraged. This effect on

investment

causes

economic growth and development to also

decline. Thus, various scholars have

attempted

to

define the relationship between debt

overhang and investment.

Krugman (1989) describes debt

overhang

as a

situation where the nominal and market

values ofexternal debtexhibita negativerelationship.

That is,

^as

the nominal value of external

debt increases, the level ofdefault increases

causing

^a

proportional fall in market value of the

debttherebyincreasingfuture

anticipated

tax on

investment returns. This, it is claimed, would

cause investment activities to decline in the future.

Claessens and Diwan (1990), explained

a

debtoverhang as " a general

situation in which the outstanding debt is so large that investment

will be inefficiently low without new money

and/or debt and debt service reductions". In

effect, the disincentive effect ^on investments

caused by external debt is that the incentive to

invest isdepressed ifoutstandingdebt isgreater

than

some

threshold level of

a

debtor country.

A common feature _among these various

definitions is that first, they highlight the

negativerelationship between

debt overhang, investment and economic growth. Second, in the

literature, agoodnumberofthe

leading authors measured debt overhang to be the debt stock as

a ratio ofGDP or debt stock as a ratio ofexports ofgoods and

services, and debt service

to

export of goods and

services. However, despite the appealing theoretical arguments put

forward on the impact of debt overhang on

private investment, empirical studies have not

entirely supported this theory.

While studies like Greene and Villanueva (1989), Oshikoya

(1992) among others,

validate the hypothesis, others like Hofman, et. al (1990), and Cohen

(1993) didnothave strong

empirical evidence

to support

the hypothesis. These results have in

large part, depended on

whether the data

were

based

on a

country specific

or

cross-country

analysis. Forinstance,the

findings of Cohen (1996) contradict his results in 1993, although the

formerwasbased oncountry-specific studywhile thelatter

relates

to

cross-sectional analysis.

InSierraLeone, similar claimhas beenmade byvarious government

officials in

respect

of the impact debt overhang ^may have

had

on

private investment1. Despite these claims,

^no

country- specific empirical research has been

undertaken in Sierra Leone to determine the

effect of debt overhang ^on private investment. Where

such

attempts were

made, Sierra Leone

was merely used among other

countries whose socio-political and economic atmospheres

are

1In1995, theGovernor,Bank ofSierra Leone(BSL)advancedsimilar claim, inapressbriefingtoprivate

investors. Helamentedthus: "Now,thedebt serviceburdenensuing fromtheobligations is ofthe orderof75%

outoftotal annualexports...The25% offoreignexchangethat is lefthastocovernormalrecurrent

expenditure,

andtherefore, there isverylittleleftoverfordevelopmentactivities. Inrelationtothe overalleconomic

developmentofthecountryit hasbeenrecognizedthat thedebt burdenconstitutes^acrippling

constraint..."

on productiveactivities.

quite different.

Some of these studies focused

on

the effect of external debt on gross domestic

investment instead of private investment but

where such attempts

were

undertaken, they

largelyignored the

contribution of private and official debt overhang in depressing investment.

The description ofthe problem suggests

that in Africa, empirical analysis

on

debt overhang is

scanty, andthis ^means thatthere

exists

^an

empirical

gap

in the literature

on a

region where the

majority ofhighly

indebted low-income countries

are

found. Therefore, this thesis attempts to

empirically contributeto

the literature of debt overhang

on

private investment in a low-income

African country and also investigate

whether debt overhang had negative and significant

impactonprivateinvestment

in Sierra Leone. In

essence,

this work closes the gap that exists in

Sierra Leone.

1.2

Objectives of the Study

The overall objective of this study

is

to

examine whether debt overhang has

any significant influenceonprivate investment.

Accordingly, the specific objectives

are

to:

♦ analyse the impact of both long and short term

debt overhang

on

private investment in

SierraLeone;

♦ evaluatetheeffect ofprivate andofficial debtoverhang^on

private investment;

♦ make debt management policy recommendations

and proposals that would enhance and

promoteprivateinvestment.

1.3 Justification ofthe

Study

Considerable interest has emerged in recent years with

regard

to

the effect of external

debt on not only private investment, but also on the

whole macroeconomic variables in the

economy. This is because as the state

gradually disengages from certain investment activities

(thatis, asprivatesector's role

increases) the problem of

severe

indebtedness would be

seen as

a potential implicit tax on

their future

returns.

It

can

discourage current investment activities.

This suggests that it is necessary to prepare

and implement

an

effective debt management

strategy

However, even ifsuchpolicy framework is

initiated, it

can

only be well focused with

adequate availability ofempirical

information and understanding of external debt structure and

itsrelated flows. Sincethis studyprovides a goodresume of the

composition,

percentage

share

ofsub-categories of the external debt owed,

it is expected that the recommendations provided

would contributetostrengtheningthenewly

established debt

management

unit in Sierra Leone.

In the 1990s, several studies investigated the effect of

debt overhang

on

private

investment (Warner (1992), Jenkins (1996),

Savvides (1992), Cohen (1993)(1996)). Some of

these studies found strong negative effect of debt overhang on

investment (Warner (1992),

Jenkins (1996). Other studies, Savvides

(1993) Cohen (1993) found that, while debt service

payments crowdsout investment,

external debt stock had

a

negative, but insignificant effect

on

investment. In view of the above and since there is no exhaustive empirical test on Sierra Leone, it is essential to undertake such study ^so

that specific policy instruments shall be

initiated ontheresultsthereof.

6

1.4

Hypotheses of the Study

The hypotheses of the study are based on

the objectives discussed above. Therefore,

themainhypothesesofthe research are as follows:

♦ Debt

overhang2

negativelyinfluencesprivate investment

in Sierra Leone;

♦ theimpactofofficial debt overhangon

private investment is negative and greater than the

effectofprivate debtoverhang;

1.5

Scope and Limitations of the study

Thecivil^warin Sierra Leoneprevented me from the

opportunity of holding meaningful

discussions with major stakeholders like officers of the

newly established debt

management

unit andprivate investors. In this case, data used ^are

largely from secondary

sources

covering

1970to 1995. The choice of the sample period (1970 to 1995) is subjected to

the availability

ofconsistent time seriesdata relevant foreconometric analysis.

Furthermore, the research is limited by lack of disaggregated

information

on some variables. Forinstance, private investmentis derivedas aresidual

of

gross

domestic investment

less public investment. Public investment is

broadly defined

^as

all investment activities that

are notcarriedoutby theprivatesector.

External debt problem of the 1980s provoked serious debate among

interested parties

(debtors, creditors and scholars) with regard to

the specification of

accurate measurement technique (Defege (1992)). These parties had different ways

in defining

a

country's external

debt. The definitions were often based ^on the interpretation and interest ofvarious agents measuring external debt. However, the outcome

of

a group

of experts'

survey

from four

organisations (Bank of International

Settlements (BIS), IMF, Organisation for Economic

Cooperation and Development (OECD),

and World Bank) has minimised this problem. They

defined external debt as " the amount at any given time, of disbursed and

outstanding

contractual liabilities ofa debtor country to non-residents to repay principal, with or

without

interest, or to pay interest, with or without principal". In

this thesis, the definition of external

debtofSierra Leoneis basedonthestandarddefinition specified above.

Private and official debts areclassified fromthecreditors' status. Private debt is simplyconsidered inthis thesis as external loansto

residents

or

entities that originate from the

private creditors like commercial banks' debt,

bonds and other private

sources.

Similarly,

official debt refers to loans to residents including the Government but extended by official

creditorsthat are fromeithermultilateral and/orbilateral sources. These definitions fit into the

standard debtclassificationofWorld Bank forwhichinterest rates,maturity and grace periods, grantselementsand other conditions areassessed.

The abovedefinition ofexternal debt excludes militaryrelated debt, because there is^no

reliable and available statistics on it. It is believed that the exclusion of military related debt

underestimates actual external debtoverhang for a country like Sierra Leone that has

financed

civil war for nine consecutive years. However, since data on military related

debt

are not

available, it is thereforenot considered às acomponent of total

external debt of Sierra Leone.

The data reporting system of Sierra Leone ^or the

creditors have either

not

reported

non- guaranteed private debt ^or such transactions

have

not

taken place within the time frame. In this

regard, gross external debt estimate doesnot

give

account

of non-guaranteed private debt.

Degefe (1992) argued that it is not very

important

to measure

external debt in real

terms, because the selection ofan appropriate deflator often

leads

to

inconsistent data series,

and atthesame time, there isvague economicmeaning as towhy it

should be measured in real

terms. Furthermore, debt and its related flows are reported in nominal values in current

US

dollars. Since the U.S. dollar is considered as a stable and strong currency relative to the

national _currency (the Leone), estimation in nominal

US$ will

account

for the country's debt

positionwell. The above limitations

did

not

significantly affect the

outcome

and robustness of

theresearch findings.

Inthe literature, thephenomenoninwhich external debtdepresses

private investment is

referredto asthe debt overhanghypothesis. Itbasicallyrefers tothe total

effect of debt stock

as

a ratio of GDP or exports and debt service ratio. In this

thesis, the effect of foreign/external

debtalso meansthe effectof debtoverhang^orExternal debtoverhang^onprivate investment.

1.6 The Research

Methodology

The study examines the problems posed by total

external debt

on

private investment.

The research methodology includes the use of published

data, trend analysis, and the

application ofeconometric techniques.

In view ofthe fact thatmajor stakeholders (central government authorities,

commercial

bank officers, and non-banking private investors) were not accessed, the

analysis is mainly

based on the ^use ofsecondary data (Chapter 4.3). The information is collected

from various

publications which include: IMF

International Financial Statistics Yearbooks and affiliated

journals, World Bank World Debt Tables

and other World Bank Publications, Bank of Sierra

Leone QuarterlyBulletins, Central Statistics Office data

publications (Sierra Leone) and from

annual budget speeches of the Government of Sierra Leone.

These

are

complemented with

articles injournals including relevanttextbooks.

The effect of debtoverhang onprivate investment (on^apriori basis) is

presented by the

use of trend analysis in Chapter 2. The^use of line graphs on available time series

data provides

visual interpretation and 'prema facie' evidence about this effect. However,

further empirical

examination through the use ofeconometric techniques is undertaken in Chapters 4 and 5 in

order to discern the effect ofdebt overhang on private investment. This method complements

rather than substitutes the trend analysis and enhances quantitative evidence on the research problem. According to Koutsoyiannis (1977), the use of

regression techniques provides

numerical estimates for the degree ofrelationship between each exogenous variable and

the

dependent variable in ^a model. Its application facilitates specific

policy implications,

10

CHAPTER 2

TRENDS IN EXTERNAL

DEBT ACCUMULATION AND

PRIVATE INVESTMENT IN

SIERRA LEONE

2.0 Preview

This chapter presents a brief resume about the

economic performance and then

a discussiononthe trend,composition and magnitude ofexternal debt

accumulated from 1970

to

1995. Also, theperformance of private sector investment is

analysed within the

context

of the

policy environment that prevailed

during the sample period. In order

to

address these issues,

ratios and relevant graphical presentations are used to describe the trends

in external debt and

privateinvestment.

2.1 The Trends in Economic Performance

(1970-1995)

Sierra Leone exhibits the typical features ofa low-income and highly

indebted African

economy with a high ratio of foreign trade to gross domestic product, a low level of

monétisation andurbanisation, and arapidly growinginformal sector. Since independence,the countryhas maintained a liberal andopen economicpolicy framework. Buoyed by favourable

world prices for the country's agricultural export commodities and by subsequent boom

in the

diamondmarket, the economyexpandedinthe 1960s,leading to sharp increases inimports

and

governmentexpenditure.

12

Between 1971 and 1973, theeconomy grew atanannual average rateof4 percent,then,

it dropped to 1.8 percent between 1974 and 1984 while it ^was

negative for

a

number of

years (see Tablel). At the ^same time, real GDP per head grew at an annual ^average

of 3.2

percent

and 0.1 percentin theperiods 1971-1973 and 1971-1981 respectively.

The trend in economic growth of the late 1970s and 1980s ^can be described as the period ofeconomic crisis in Sierra Leone. The lull

in economic growth during the 1970s is

claimedto have emanated from theoutbreak ofthe 1973/74-oil price increase. The increase in

oil priceis argued to have resulted to increasein import bills,

causing excessive

use

of foreign

reserves, expansion in budget deficit and worsening balance of payments account. For example, foreign reserves declined from 55 million dollars in 1973/74 to 28

million dollars in

1975, while budget and current account deficits increased from 5.3percent and 12.7 percent in

1974 to 12.6 percentand 13.2 percentin 1975 respectively (allas apercentageof GDP).

These trends contributedto thedecline in economic growthrate to -4.3 percent in 1976

from 5.3percent and 2.6percentin 1974and 1975 respectively (seeTablel). By the late 1970s,

economic growthrateimproved to 8.0percent,but this trendwas countered by the effect of the

second oil price increase in 1979. The effect of the oil-price shocks and poor economic managementimpeded economic at the beginning of 1980 and then slumped into crisis by the

end of 1980s. Sincethen, economicgrowth has not significantlyimproved. At the beginning of

the 1990s, economic growthwas still below acceptable targets. In 1994, the growthrate was -

2.6 percent, while it further deteriorated to -9.9 percent in 1995 (see Table 1). This weak performance is also reflectedin declininginvestment and savings^{rates as} well as unsustainable

external sectorbalance.

Domestic inflation rate was not a major economic problem during the period 1970-

1974. As seen in Table 1, changes in CPI were insignificant or negligible

during the period

1970-1974, causing inflation rate to revolve around zero percent.

Thereafter, inflation

proceeded at a low rate of 3.2 percent from 1974 to 1975, but

during the period of economic

stagnation (in mid 1970s),inflationrate quadrupledto 12.6 percent

(see Table 1). Then, when

the economy slipped into decline in the 1980s, inflation again

quadrupled

to over

50

percent

per year although the average annual CPI was 21.7 (see

Table 1). Weeks (1992) empirically

demonstrated thatinSierraLeone, thehighrateofinflationwasmainlycaused by expansion in

money supply during the 1980s. During this period, money

supply tremendously expanded,

while realoutputgrowthrate either stagnatedordeclined.

At the beginning of the 1990s, reduction in money supply became a pre-condition imposed by IMF andWorld Bank forgranting stabilisation and structural adjustment

facilities.

Money supply considerably reduced from 33 percent in 1992 to 11 percent in 1995 (see BSL 1995). This contributed to the decline in inflation rates from 110 percent in 1991 to about 22 percent in 1994. However, in 1995, the rate of inflation rate was 34.5 percent, a trend caused byvarious cost-push factors in theeconomy.

During the past two decades, government fiscal policy ^{was one} of the areas of weak

macroeconomic management. The fiscal deficit ^{as a} ratio of GDP (on ^a commitment basis)

increased from 1 percentin 1970to 3.4percentin 1973, 16.8percent in 1979, while it declined

to 6.8 percent in 1986. By 1994, the overall fiscal deficit of 6.2 percent was above the

estimated target by 0.3 percent of GDP and by end of 1995 fiscal year, it was 7.0 percent of

GDP (see Budget Speeches, 1991/92,

1993-1996). In effect, the fiscal account manifests

persistent deficit

for nearly all the

years.

One of the questions asked is how the persistent

deficit was financed. Not unlike most African countries, the deficit was

largely financed

throughdomesticmonetary

accommodation and excessive borrowings by the government from

the private financial

institutions. Borrowings from banking institutions and external sources

compounded the problemof

budgetary control and worsened the economic crisis of the 1980s.

The overall picture shows that

economic growth has been sub-optimal throughout the sample

period,particularly during the

1980s.

Tablel: Some Macroeconomic Indicators

Year GDPGrate CPI GDI PVI GDS DEF EXP IMP TB TOT CA RES

1970 412 10.5 0.2 16.6 6.8 14.7 ^— 100 105 -5 133.5 -03.9 39 1971 426 3.0 0.2 15.2 7.2 14.0 -1.1 96 103 -7 129.8 -04.5 38 1972 445 -0.9 0.2 11.8 7.4 11.8 -2.3 113 108 5 122.7 -02.0 47 1973 457 2.8 0.2 11.0 7.5 10.9 -3.4 129 141 -12 127.4 -06.3 52 1974 481 5.3 0.2 15.9 7.9 8.6 -5.3 143 199 -56 121.4 -12.7 55 1975 494 2.6 0.3 15.7 7.6 6.5 -12.6 129 168 -39 105.8 -13.2 28 1976 473 -4.3 0.3 11.2 7.7 2.8 -8.6 114 150 -36 121.3 -12.5 25 1977 475 0.6 0.4 13.2 7.4 6.6 -8.3 143 165 -22 146.7 -10.3 33 1978 460 -3.1 0.4 11.2 7.0 3.9 -12.4 185 253 -68 124.5 -24.3 35 1979 497 8.0 0.5 13.4 7.2 0.7 -16.1 197 336 -139 122.1 -36.0 47 1980 575 3.1 0.6 16.1 3.5 -0.8 -13.9 213 386 -173 106.3 -28.7 31 1981 625 8.7 0.7 19.0 11.4 4.4 -11.9 152 282 -130 101.3 -20.9 16 1982 625 0.0 0.9 13.4 7.8 1.9 -13.2 110 260 -150 103.0 -25.6 08 1983 606 -3.1 1.5 14.3 8.8 7.5 -16.2 107 133 -26 105.4 -2.9 16 1984 567 2.3 2.5 12.7 10.8 11.1 -11.8 133 149 -16 111.4 -4.1 08 1985 537 -3.4 4.4 10.9 6.2 8.8 -10.7 132 141 -9 106.2 -3.7 11 1986 525 -1.9 7.9 10.6 6.9 9.1 -6.6 126 111 15 105.2 -0.9 14 1987 834 5.4 22.0 9.1 4.5 9.7 -52.6 139 115 24 100.0 -8.8 06 1988 850 3.3 29.5 9.8 6.0 7.6 -11.0 104 138 -34 118.7 -0.4 07 1989 892 4.2 47.4 9.1 6.7 3.9 -10.5 139 160 -21 102.7 -6.7 04 1990 915 3.0 100.0 10.4 5.9 4.6 1.3 140 140 0 127.1 -7.5 05 1991 836 -8.7 202.7 9.3 6.1 9.1 -3.0 150 138 12 105.0 1.8 10 1992 757 -9.4 335.5 10.5 3.6 9.5 -5.9 145 145 0 94.5 -0.8 21 1993 757 0.1 410.0 7.8 2.4 4.3 -1.9 139 156 -17 120.5 -1.3 33 1994 784 3.6 509.2 8.5 4.1 3.4 0.7 118 149 -31 106.4 -4.5 50 1995 707 -9.9 641.5 5.6 3.0 -9.1 12.1 42 137 -95 145.0 -15.9 52 1970-74 444 4.1 0.2 14.1 7.4 11.9 -3.0 116 131 -15 126.9 -5.9 46 1970-80 472 2.5 0.3 13.8 7.0 7.3 -8.4 142 192 -0.2 123.8 -14.0 39 1981-90 698 1.9 21.7 11.9 7.5 6.9 -14.3 128 163 -34.7 108.1 -8.2 9.5 1991-95 768 -4.9 419.8 8.3 3.8 3.4 0.4 119 145 -26.2 114.3 -4.1 33.2 Source: IMFFinancialStatisticsYearbook, World BankWorld Tables, and African

Note: GDP isReal GrossDomesticproductat 1987

prices in US$ Million

GRATE⁼GrowthrateofrealGDP, CPI =Consumerprice

index

GDI =Grossdomestic investment as apercentageof GDP

PVI =Private Investmentrate,GDS =Gross Domesticsavingsrate

DEF =Fiscaldeficitas apercentageof GDP

EXP =ExportsinMillion of

US$,

IMP =

Imports in Million of US$

TB = TradeBalance, TOT= TermsofTrade

(1987=100)

CA ⁼Currentaccountbalanceas%ageof GDP andRES=

Total external Reserves.

2.2 The

External Debt Accumulation and Its Burden

2.2.1 The

Magnitude and Description of External Debt Accumulation

Table 2 presents information on

the accumulation of total debt stock, its composition

and structure forthe period 1970-1995. In 1970,

Sierra Leone's total outstanding external debt

amountedto $59million,butthis amountincreasedto $90million

in 1973 and then,

more

than

doubledto $199 million in 1974 (anincrease ofmore than 100

percent). The sharp increase in

external debt from 1973 to 1974 is attributed to the 1973/74—oil

price increase. The price

increase ledto increase in the prices ofall imported items.

Since the

export

earnings

were

not

adequate to offsetthehigh import bills, government

intervened into the market by subsidising

thecosts ofcertain importables likericeandpetroleum

products. The payments for these items

led to accumulation ofhuge foreign debt in the subsequent years.

However,

as

external debt

stock gradually increased, thepressureto make

debt service payments heightened and in order

to fulfil the payments obligations, the government

had

to

exhaust the country's external

reserves.

In 1980 (the year after the

second oil price increase), external debt amounted to $433

million from $379 million in 1979 (see Table 2). This increase ^was not

unconnected with

increase in foreign exchange demand to pay

for oil imports and also the foreign exchange

16

requiredfor

financing the Organisation of African Unity (OAU) summit held in 1980. In order

to finance the summit, short-term loans were

contracted

at

non-concessional terms,

exacerbating the upward trend in

external debt obligations. In Sierra Leone, it is claimed that

the total cost that was involved in hosting this summit did not

only reduce the country's

external reserves,butit severely depleted

domestic savings from US$5 million in 1979 to US$

-8.5 million in 1980 (ADI, WorldBank, 1995). At

the

same

time, there

was

increase in budget

deficit and also registered high net claims ^on government

from the financial institutions. The

trendinexternal debtaccumulationcontinued unabatedduring the

1980s, and

at

the beginning

of the 1990s, government policy

decisions

were

significantly influenced by huge debt burden.

In 1990, external debt amountedto $1,206

billion, $1,452 billion in 1993 and then moderately

reduced to $1,226 billion in 1995 (an amount substantially higher

than the 1970s and 1980s

figures).

External debtcan beclassified into short and long term debt. In viewing

the country's

external debt situation from this aspect, the country was not

indebted

on

short-term basis

during the period 1970-1976. If short-term debt

existed, then, it

was

not reported in the

country's external debt profile. However, in 1977,

the Government contracted short-term debt

tothetuneof$20 million (about 8 percentof total debt

owed in that year). By 1980, short term

loans amounted to US$54 million, while it increasedto US$446 million

and US$ 498 million

in 1990 and 1994 respectively (see Table 2). The above

discussion implies that during the

period 1970-1976, thetotal amount

of external debt

was

entirely based

^on

long term basis.

The share oflong-termdebtgradually diminished^as

the

economy

became saddled with

crisis. At theend of 1970s andduringthe 1980s (forwhich the SierraLeoneaneconomy was

in