BUSINESS WORLD Economic Growth and External Debt in Sierra Leone Posted by on Jul 2, 2008, 18:17

The desire for economic growth drove developing countries to industrialization, which was seen as the engine of economic growth. In industry, as in any other sector, the industrialization process for its very essence is inconceivable without the introduction of new equipment. In developing countries this gives rise to one of the most intricate and difficult problems. The building of modern enterprises is based on capital-intensive equipment, which is designed to increase output with a saving of labour.

New enterprises of this kind increase only insignificantly the demand for manpower, and then only for manpower possessing certain skills. This implied that building of individual enterprises does not help to reduce unemployment. The limited demand for manpower, especially after the enterprises are commissioned is a characteristic feature of modern industrial construction, making impossible the solution of the unemployment problem.

Sierra Leone, for instance, once enjoyed a relatively high living standard in the 1960s; attractive GDP growth rate of about 4% per year; and a stable political and social system.  However poor economic policies and deteriorating external terms of trade in the 1970s led to substantial declines in incomes. By the end of the 1980s, the deterioration in the economic situation was so sharp that macro economic indicators such as the gross domestic Product (GDP), inflation rates, and balance of payment became uncontrollable; hence the economy became practically unmanageable. The widening gap between imports and exports led to heavy indebtedness to international financial institutions such as the World Bank and the International Monitoring Fund.

 By the 1990s, the country was classified as one of the poorest countries in the world with widespread poverty, high infant mortality rate about 182/1000 and life expectancy, among the least in the world, about 38 years; low adult literacy rate estimated at 30% while only 35% of the population had access to safe drinking water in 1998 (UNDP) Human Development Report, 1998).The country was ranked bottom of the 174 countries listed in the UNDP’s Human Development Reports from 1991 to 2004.  

The 10-year launched in 1991 only served to exacerbate Sierra Leone’s already tragic situation.  The war is largely believed to account for the negative GDP growth of – 4.3% from 19992 to 1998.  The impact of the war cut across all sectors including educational and health facilities, rural and urban settlements, social and economic infrastructure including roads, bridges, and industrial structures. The continuing decline in economic performance worsened the poverty situation in the country, and hence brought misery and frustrations for most Sierra Leoneans. The proportion of the people living below the poverty line of $1 per day increased considerably from about 80% in 1990 to about 90% in 1999(I-PRSP, 2001); while in  2004, 70% of the population could not afford basic necessities such as food, safe water and sanitation, shelter, good health, and basic education (PRSP, 2005).

The economic and social situation in the country remains fragile and vulnerable to domestic and external shocks, and the country has a long way to go to make up for the ground lost over the past decade of the civil war. Despite some upturn in economic growth rate (7.2% in 2005), poverty is still widespread and in many parts of the country extremely acute. The proportion of the people living below the poverty line of $1 per day increased considerably from about 80% in 1990 to about 90% in 1999(I-PRSP, 2001); while in  2004, 70% of the population could not afford basic necessities such as food, safe water and sanitation, shelter, good health, and basic education (PRSP, 2005). Sierra Leone therefore faces major challenges: to raise growth and reduce poverty, and to integrate itself into the world economy. The benefits of economic growth are still not widely distributed enough to make a real dent in the pervasive poverty and enable this country to catch up with other developing nations. What is needed is a sustained and substantial increase in real per capita GDP growth rate in the country, coupled with significant improvements in social conditions.

The External Debt Burden

Since the 1970s, developing countries, including Sierra Leone, have borrowed large amounts, often at highly concessional interest rates and extended grace periods. The hope was that these loans would put them on a faster development path through higher investment and faster growth. But as debt ratios reached very high levels in the 1980s, it became clear that for many of these countries, repayment would not just constrain economic performance but be virtually impossible. Thus, in the 1980s, several middle-income countries—particularly in Latin America—faced severe debt crises and, in the mid-1990s, the IMF and the World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative to bring the debt of low-income countries—most of which are in sub-Saharan Africa—to sustainable levels. Despite the importance of this issue and the public attention it has received policymakers and researchers around the world still have only a partial understanding of fundamental questions, such as

·        Beyond what level does external debt impair economic performance?

·        What are the channels through which debt affects growth?

·        What effect on growth can we expect from the debt reduction associated with the HIPC Initiative?

Economic theory suggests that reasonable levels of borrowing by a developing country are likely to enhance its economic growth. Countries at early stages of development have small stocks of capital and are likely to have investment opportunities with rates of return higher than those in advanced economies. As long as they use the borrowed funds for productive investment and do not suffer from macroeconomic instability, policies that distort economic incentives, or sizable adverse shocks, growth should increase and allow for timely debt repayments. These predictions hold up even in theories based on the more realistic assumption that countries may not be able to borrow freely because of the risk of debt repudiation.

The Debt Burden

Sierra Leone accumulated debt in the 1970s through the 1990s. the debt burden became very severe, with the debt overhang having a negative impact on new investment and economic growth. The severity of a country’s debt burden is often expressed in terms of its debt servicing obligations—the repayments of principal and interest due in a given year. A common rule of thumb is that the debt service due should not exceed 30 percent of a country’s export earnings. Beginning in the mid-1970s, the debt servicing problems became both more general and more intractable. First, following the 1973 oil shock and the subsequent global recession, many African primary-producing countries encountered balance-of-payments difficulties. Then, after the sharp rise in world interest rates in the early 1980s, most middle-income countries that had borrowed from banks were unable to service their debt. The need to resolve the debt problem overshadowed many other development issues. Thus, improving the quality of external debt management has become a vital aspect of public administration.

The Effect of the Debt Burden on Economic Growth

There are two main channels through which excessive external indebtedness negatively affects economic growth. There are: the Debt Overhang Effect and the Crowding out Effect. The debt overhang effect shows that if there is some likelihood that, in the future, debt will be larger than the country's repayment ability, expected debt-service costs will discourage further domestic and foreign investment and thus harm growth. This is so because, firstly, the debt overhang can act as an anticipated foreign tax on both current and future income levels.  Potential investors will fear that the more a country produces, the more it will be "taxed" by creditors to service the external debt, and thus they will be less willing to incur costs today for the sake of increased output in the future. Secondly, there is the credit rationing effect. An indebted country is likely to face credit constraints in the international markets; the reduced access to international financing will shift repayment of foreign debt to the domestic sector. Thirdly, government is responsible for making payments; this forms a significant part of the budget with dire consequences for other development projects. The incentive effects associated with debt stocks tend to reduce the benefits to be expected from policy reforms that would enhance efficiency and growth, such as trade liberalization and fiscal adjustment: the government will be less willing to incur current costs if it perceives that the future benefit in terms of higher output will accrue partly to foreign lenders.

 The total debt-GDP ratio is used to capture the debt overhang effect on growth. The ratio gives the proportion of current income of the debtor country that would be channeled to servicing the debt burden. It shows how much of the domestic resources that would be required to service the debt obligations. The World bank/IMF cut-off ratio for this is 0.5 (50%). That is, when the debt-GDP ratio is above 0.5 it shows that the debt burden for that country is severe.  In the past, Sierra Leone has endure very high debt-GDP ratios; the 1980s the ratio averaged at about 60% of GDP, while in the 1990s the average is about 80% of GDP. This leap in the ratio is of course due to the rebel war, which disrupted economic activities and brought above heavy dependency on foreign aid in the country.

The Crowding out effect of external debt arises from the fact that many highly indebted poor countries frequently divert resources to take care of pressing debt service obligations, particularly debt owed to multinational institutions like the World Bank and IMF, which is deemed ‘non-reschedulable’. The debt service-export ratio (debt service ratio) is used as a proxy to capture the crowding out effect. This is the proportion of exports that are used to service the debt. The World Bank cut-off debt service ratio is 0.3 (30%).  The rationale is that much diversion of exports to debt servicing crowds out public investment and discourages private investment because of the complementary between them. In the 1990s Sierra Leone endured debt service average ratio of 0.4 (40%) of export. In 2003, Sierra Leone spent 10.9% of export of goods and services to service her debt obligations.

Debt relief

In 2006 Sierra Leone reached it completion point under the HIPC initiative should saw the cancellation of over 80% of the country debt owned to international institutions like the IMF and World Bank. It is therefore absolutely important that an adequate debt management strategy is put in place, which should involve the monitoring of loan contraction, utilization and repayment (debt-servicing).