THE COVID-19 DEBT TRAP: An African perspective

by Business Zone

The shocks from the COVID-19 pandemic and the ongoing price war on crude oil have not only affected business and financial cycles globally but have also significantly impaired the public finances of several countries.

The impact of this unprecedented shock has led several developed and African countries to commit themselves to spend several billions of dollars by increasing their budget deficits in order to restore faith in the economic system and consequently stimulating the economy.

Japanese Prime Minister Shinzo Abe announced a $989 billion stimulus package for Japan. In the same vein, Donald trump of the United States and Chancellor Rishi Sunak of the United Kingdom unveiled stimulus packages worth a trillion dollars and 200 billion pounds respectively. Nigeria, Africa’s largest economy is seeking $6.9 billion from lenders. Likewise, Ghana is requesting almost $892 million from the International Monetary Fund (IMF) and the World Bank.

Global responses to the pandemic:

Truly, debt accumulation by the government might indeed be inevitable in this COVID-19 war as countries endeavour to escape deep recessions, howbeit, these spending interventions have to be guided along with a theoretical economic framework to fully understand their implications and assess them for optimality.

On one hand, it is the Monetarist framework which argues that recessions could be avoided by increasing the broad money supply in an economy. A typical example is the Quantitative Easing in developed countries that buys assets from the corporations and the corporations spend on business expansion or investment as their money to asset ratio balances rises above the desired level.

On the other hand, it is the Keynesian framework that presupposes that recessions could be avoided by increasing government spending on providing social amenities which will increase the productive capacity of the economy and also reducing the tax burden on the household so they could consume more.

It is obvious from the above that most of the interventions by African countries are based on the Keynesian ideology. However, is this framework rightly implemented in Africa and what are its long-term consequences?

Debt Accumulation in Africa: Consequences and Rationale

The immediate celebration that ensued demonstrates that market participants believe that accumulating debt is without economic consequences and so should be the least of our worries at this present moment.

However, an assessment of the responses to the outbreak reveals that the huge debt accumulation would deal a severe blow in terms of inflation and Exchange rate devaluation, particularly the African context due to the structure of their economies.

Firstly, the huge spending would have a severe impact on the African economy if the debt is not employed in increasing the productive capacity of the economy but instead on freebies. In the long run, the nations will be faced with inflation which will hurt its citizens, especially the poor.

Another scenario is that the government is going to choose to “pay” for this debt by means of higher taxes, still impacting adversely on the household, in particular citizens on low wages.

The rationale is that, once the pandemic is over, the purchasing power of many would have increased due to all or some of these reasons: Governments direct cash payments, utility bills absorbed by state and the savings done during isolation.

With this new purchasing power, there will be more money in circulation for fewer goods to buy as a result of a reduction in production. Section of the workforce is prevented from working because of social distancing.

Aggregate demand will therefore exceed aggregate supply leading to an inevitable increase in prices (inflationThe government would therefore be faced with allowing prices to rise or increasing taxes to reduce purchasing power and subsequently consumption.

Secondly, because most African economies are characterised by high imports and low exports, the increase in purchasing power would lead to more goods and services been procured from abroad, resulting in an increase in imports and as such more demand for foreign exchange.

The significant rise in the demand for dollars will result in massive depreciation and potentially a devaluation of the national currency. The consequences are that goods and services imported will be more expensive, another blow to the poor.

An illustration, assuming a bag of imported rice cost 300 GHS and the exchange rate is 1 USD = 5.78 GHS. That means the rice costs approximately 52 USD. If the cedi depreciates significantly, the new exchange rate could be 1 USD= 6.5 GHS, meaning the new price of rice will be 338 GHS. That is a price increase of about 12.6 %. 

Way Forward?

The solutions are but not limited to the following: Policymakers should monitor broad money supply to ensure it doesn’t rise significantly above the potential growth of the economy. This will help curb the negative impact of inflation.

Second, governments should consider reducing the tax rates of businesses affected to aid in their recovery once the pandemic comes to an end. A reduction in corporate tax rates could attract foreign direct investments, leading to an augmentation of capital stock, productivity and output. This also has the potential to slow down imports and save the national currency.

Third, we need to develop capital markets which will help in developing a more effective market-driven response to economic shocks.

Lastly, government borrowing should be employed in increasing the productive capacity of the economy. Employing these approaches will rather increase the aggregate wealth of the African countries in the long term instead of raising the country’s debt.

Source: Kwasi Nyame-Baafi, Ph. D Candidate in Economics at The University of Buckingham, UK, Co-founder of the Haimehen Economic Institute

Kwasi Nyame-Baafi and Vice President Bawumia

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