International reserves, currency depreciation and public debt: New evidence of buffer effects in Africa☆

https://doi.org/10.1016/j.ememar.2024.101130Get rights and content

Highlights

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    We explore the relationship between international reserve and public debt in Africa.

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    Higher foreign currency reserves have a positive impact on reducing the public debt.

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    This effect is observed during periods of large exchange rate depreciation.

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    The impact varies among countries according to the exhange rate regime.

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    Policymakers could use international reserves to maintain sustainable public debt.

Abstract

The paper adds to the literature on the issue of public debt in African economies, by investigating the role foreign exchange reserves play in improving the level of indebtedness and as buffer of the negative effect of exchange rate depreciation while considering the exchange rate policy. Our results show a direct link between the level of foreign currency reserves and that of external debt in Africa. Particularly, we demonstrate that higher foreign currency reserves tend to decrease the public debt stock to GDP. This effect is even more significant when countries go through high exchange rate depreciation episodes (10% or higher). This impact, however, is not homogenous among country groups, as only countries with a floating exchange regime tend to benefit from this buffer effect compared to anchored regimes. In a time where most African economies face severe exchange rate depreciation episodes following the U.S. monetary tightening policy, central bankers and policy makers need to consider a plethora of policy issues including interventions in the FX market to mitigate depreciations and maintain a sustainable public debt stock.

Introduction

After the global financial crisis, the persistence of low interest rates has raised several questions in public debates. The consequences on public debt dynamics have been at the center of the stage. Blanchard (2019) argues that public debt is not safe even with persistent low interest rates. The author underlines two important points about too large a public debt-to-GDP ratio, namely: (i) it may reduce capital accumulation; therefore, the welfare costs may be higher than expected; and (ii) it could induce multiple equilibria where investors require a risk premium. Thus, the fiscal costs of debt are lower than in a high interest regime, but governments still have strong incentives to maintain their debt trajectory on a sustainable path.

In 2022, we entered a high interest rate cycle to tame inflation at the global level. The U.S. has led their most aggressive tightening cycle since at least 1983 resulting in a strong appreciation of the US dollar against other currencies, particularly for countries that do not have enough margin to support their currency. For many African countries, this tightening monetary policy cycle around the world has meant slowing external demand, higher domestic interest rates, elevated sovereign spreads, and ongoing exchange rate pressures (see International Monetary Fund (IMF), 2022; International Monetary Fund (IMF), 2023). As a result, their debt increased to reach an unprecedented level since the majority of African countries benefited from debt relief initiatives, namely under the Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI). Fig. 1 shows that the public debt-to-GDP ratio in most African countries has been higher than 50% on average over the period 2015–2022.

As highlighted by African Development Bank (AfDB) (2021), the exchange rate depreciation is one of the main drivers of public debt in Africa. Indeed, exchange rate depreciation affects the public sector balance sheet, and its effect is exacerbating in emerging and developing countries facing among others the phenomenon of “Original sin”1 (see Section 2). To overcome this phenomenon, developing countries may decide to manage international reserves strategically to buffer the impact of external finance shocks (Ahmed et al., 2023; Aizenman and Riera-Crichton, 2008).

The question of holding international reserves in African economies have important implications, as it may have welfare costs (Ben-Bassat and Gottlieb, 1992; Rodrik, 2006; Korinek and Serven, 2016). This arbitrage may be delicate in economies with growing needs for investment and local development plans and subject to a continuous series of global shocks: severe repercussions on the supply chain brought about by Covid-19 and the Russia-Ukraine war, among others. According to the International Monetary Fund (IMF), the median public debt to GDP ratio has risen by 30 percentage points between 2012 and 2022 to reach 59.1%, following a decade of sharp decrease (Lemaire et al., 2023). Ample scholarly research has been published on the external public debt issue and its impact on growth and other development targets. Kedir et al. (2023) looked at a sample of 49 African economies during the 1991–2018 period; they showed that external debt could have a negative or a positive impact on growth depending on the institutional context, particularly the governance quality. Moreover, external debt could be impacted by the change in other macroeconomic indicators such as the exchange rate depreciation or appreciation, as well as the exchange rate regime. IMF researchers found that since the onset of the COVID pandemic, exchange rate pressure (depreciation) has led to a 10 percentage points increase in public debt on average in sub-Saharan African countries. The increase is estimated to be higher among non-pegged exchange rates regimes (Kemoe et al., 2023).

Following this introduction, the rest of the paper is organized as follows. Section 2 provides a summary of recent literature exploring the interaction between exchange rate, international reserves holding, and public debt in Africa. Section 3 outlines the empirical methodology used to answer the research questions. Section 4 details the empirical results and their interpretations. Section 5 concludes with a summary and policy implications for African economies.

Section snippets

Literature review

The theory on the dynamics of public debt indicates that the level of public debt depends on several macroeconomic variables, including: the nominal interest rate, the inflation rate, the real growth rate, the depreciation of the nominal exchange rate (depending on the weight of foreign currency-denominated external debt), and the primary deficit (Greenidge et al., 2010). Concerning the relationship between public debt and the exchange rate, the literature relies on the balance sheet effect of

Data

For our analysis, we use different sources as outlined in the Appendix A. Initially, we conduct a simple descriptive analysis on the indicators of interest. As illustrated in Fig. 2, we note a negative linear relationship between FX reserves in 2021 and exchange rate depreciation in 2022 for 52 African economies. The plot shows that as the country's foreign exchange reserves increase, it is less likely to experience depreciation. For instance, for countries with high reserves emanating from oil

Empirical results

The results from the regressions of Eq. (1) are reported in Table 1. They confirm the existence of a negative and significant relationship between ex-ante foreign exchange reserves and currency depreciation in African economies. In other words, countries that have accumulated more foreign exchange reserves are more likely to limit the depreciation of their currency. The buffering impact of reserves seems statistically more significant (at the 1% level) for countries facing high depreciations of

Robustness checks

In this section, we test the robustness of our results by considering the persistence in the dynamics of public debt (explained variable in Table 2, Table 3) as well as the endogeneity which could characterize the relationship between reserves and debt. Indeed, debt being a stock variable, the debt-to-GDP ratio could show strong persistence. Furthermore, the introduction of a lag on foreign exchange reserves might not be sufficient to consider it as a completely exogenous variable in its

Conclusion

Our paper provides evidence that monetary policy tools mitigate the impact of the rising public debt in African economies. Using both pooled OLS and the Driscoll-Kray estimators, we confirm that holding foreign exchange reserves has a buffer effect against rising public debt, and particularly during periods of high depreciation of exchange rate as experienced most recently with the United States monetary policy tightening. Additionally, we account for heterogeneity among the 52 African

Acknowledgment

The authors are grateful to Katharina Priedl, Claire Mainguy and Joshua Aizenman for useful comments.

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    The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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