In a practical sense, governments borrow to grow their economies. Borrowing is synonymous with economic growth. Businesses use leverage to boost profits. And in the context of real output, countries leverage by borrowing money to maximise their gross domestic products (GDPs). Any country with a vibrant economy will borrow to sustain economic growth.
For example, since the late 1990s, African countries have been enjoying resurgence in economic growth due to fiscal reforms. However, economic growth brings its own challenges such as the need to build new infrastructure. It is a well-known fact that infrastructure is lagging economic growth in Africa.
According to the Africa Infrastructure Country Diagnostic (AICD), Africa needs to spend $93 billion a year; half on investment and the other half on maintenance in order to raise the regions infrastructure endowment to a reasonable level. This is a tall order for a continent where only five countries (Nigeria, South Africa, Egypt, Angola, and Algeria) have nominal GDPs that are higher than $100 billion, according to the World Economic Outlook’s data base, April 2011. It is very clear that African countries must borrow to be able to build new infrastructure. If they do not borrow, economic growth and development will be jeopardised.
Convenient Way To Increase Economic Growth
Borrowing is a convenient way to increase economic growth. Assume an investor wants to build a car assembly plant in country A, where the business environment is attractive. Country A doesn’t have a functional seaport and doesn’t have the money to build one. Armed with a population, natural resources, a reform oriented and growing economy, they can go to the bond market or international organisations to borrow money to build that port. What the new port will do is increase trade because cars manufactured in the country can now be exported via the new port. In other words country A, has increased output through borrowing.
This also means that building a car plant in Ibadan, Oyo State, will require functional ports to import inputs as well as export finished goods. Functional road and rail networks will be needed to transport goods to different parts of Nigeria. On the consumer side, building of a car plant means economic growth; it increases rural urban migration because people will flock to the city for work and a better life. This migration means that government has to invest in education, healthcare, housing etc. These are massive capital projects; hence governments in Africa must borrow to close the gaps.
Nigeria’s debt declined between 2000 and 2011. The reason for the sharp reduction in debt levels between 2004 and 2006 was the policy of debt payoffs and write-offs that was negotiated by the current finance minister, Ngozi Okonjo Iweala, during the Olusegun Obasanjo administration. That was also the period when Nigeria began to run a countercyclical economic policy and therefore was able to accumulate foreign reserves. The Nigerian economy expanded rapidly between 2001 and 2007 due to reforms in the telecommunication and financial sectors, as well as high oil prices in the international market amongst others. The Nigerian middleclass also re-emerged in this period because of the new jobs that were created due to wide ranging reforms in different sectors of the economy.
The Nigerian government enjoyed significant inflows of investment between 2004 and 2008 because of low debt. The naira appreciated during this period, and the economy was more efficient because the telecommunication revolution meant that a significant number of Nigerians had functioning telephones. This development marked an improvement in the nation’s infrastructure which ramped up economic growth.
After 2008, Nigeria’s debt increased from 1.3% to 16.7% in 2010. The global recession in 2008 crashed oil prices, triggered a banking crisis, caused capital flight, reduced revenue to the central government, depreciation of the naira and job losses. The Nigerian government depleted her foreign reserves to support the naira and had to borrow to support consumption, mostly inform of bailouts for troubled sectors of the economy. Also, election spending in 2010/2011 contributed to the worsening of government books. In other words, Nigeria had a much more accommodative policy post 2008, as opposed to the countercyclical policy it ran before 2008. A mild global recovery and an uptick in oil prices reversed the nation’s fortunes and led to a slight reduction in debt since 2010.
Drivers Of Nigeria’s Debt
Usually, as an economy grows, it takes on more debt to finance economic development. Ironically, the opposite is the case in Nigeria. Nigeria has maintained extraordinarily low debt levels since 2005 even though the economy has been enjoying 7% growth, according to the National Bureau of Statistic. Nigeria has a very poor road and rail network, power supply is inadequate, Nigeria has only one functional seaport, while airports around the country need upgrading. Therefore, significant outlays of capital will be required for education, health, security and other services due to rural urban migration and population growth. It is expected that Nigeria will take on more debt in the future for these reasons.
On the business side, firms will need to expand to do business in a growing economy like Nigeria. They will have to borrow money from banks or through the capital market to finance operations. Banks will need to merge or partner with other financial institutions to be able to provide credit to the private sector.
Economic Implications For Current Leverage In Nigeria
According to the International Monetary Fund (IMF), Nigeria’s current debt to GDP ratio estimate is 9.9%. This is impressive considering the fact that Eurozone countries have debt to GDP ratios higher than 60%. The economic implications of this low debt profile are:
1) Nigeria will be able to attract foreign direct investment because a low debt ratio means that the economy is fairly well managed.
2) The government can pay her bills and meet financial obligations
3) The consumer class is buoyant; an important factor for investors because people will be able to pay for goods and services.
4) Businesses are profitable because they do not spend a significant chunk of earnings in debt servicing
5) The tax rate is not too high, and there will not be significant tax increases in the future. Countries with high debt ratios usually raise taxes so they can reduce debt. A higher tax reduces profits for businesses and disposable incomes for the consumer. It is very risky to do business in such an environment and investors flee such countries.
6) Nigeria can easily borrow money in the future because of good government books.
7) Economic growth is not endangered
The behavior of advanced countries and the BRICS (Brazil, Russia, India, China, and South Africa) shows that there are no international standards for borrowing. The fact that Canada and Australia are advanced economies but have debt ratios below 35% and, India and Brazil are emerging markets but have debt ratios higher than 60% means that there are no international standards for borrowing. Today, advanced countries (66.1%) on the average have higher debt than the BRICS (41.7%); available data from the IMF has shown.
While emerging markets have a deliberate policy of low debt, the policy in advanced economies is to borrow as much as they can, as long as they do not default. A low debt ratio is not necessarily an indicator of development. Sub-Sahara African countries have some of the lowest debt profiles in the world today, but are the least developed countries. The BRICS also have lower debt ratios than advanced economies, but are not as developed as the advanced countries.
Does An Optimal Debt To GDP Ratio Exist?
The answer is “NO”. Every country borrows according to policy and capacity. Nowadays, the key indicator is “DEFAULT”. Countries will continue to borrow as long as they are certain they will not default.
The optimal debt to GDP ratio is one that allows a country to achieve highest possible growth without default. An empirical study by Carmen Reinhart and Kenneth Rogoff suggested that economic growth begins to suffer when a country's debt-to-GDP ratio exceeds 90%.
Logically, a debt to GDP ratio higher than 45% is a threat to economic growth. If an individual’s total income is ₦1 and this individual owes 45 Kobo (debt ratio of 45%) or less, he or she is in a better position to reduce the debt. However, if your debt is higher than 50 kobo, it leaves you with less money to spend, save, invest etc. Creditors will be unwilling to lend to you because you will spend a considerable amount of your income paying off debt.
It is best for Nigeria to follow the BRICS model where on the average, debt to GDP ratio is 41.7%. Advanced economies may have the luxury of running up debt because they have developed institutions, and are therefore considered safe for investment; even if returns are very poor. However, advanced economies will still be trapped in a recession because of the debt they have accumulated, with very poor growth prospects in the near to mid-term.
Leverage is when a business uses borrowed money to increase the rate of return. It is also known as the debt to equity ratio. High debt to equity ratio signals that a company is heavily leveraged and is financing much of its operation through debt. The disadvantage of borrowing for business is that it can cripple the company, if the investment turns against the business.
In real output, leverage is when a country borrows money to maximise gross domestic product (GDP). It can also be expressed as the debt to GDP ratio. It is an indicator of the health of an economy. A high debt to GDP ratio means that the economy is not productive enough to cover borrowing costs. Governments usually target a low debt to GDP ratio because it means that the economy is well managed, productive and profitable for business. It is also an indicator that the government can pay her bills. Investors typically avoid countries with a high debt to GDP ratio.
The business and economic implication of a high debt ratio is that government would tax firms and individuals to repay debt and that means lower profits and even lower consumer base for businesses. It leaves households with fewer savings and reduces consumption. Through lower profits, revenue to the government is negatively affected, thereby grossly increasing the likelihood of default.