Zambia's Domestic Debt Dilemma: A Frontier Market Crossroads for Investors

Zambia's recent debt restructuring, framed within its IMF-supported program, has thrust the small African nation into the spotlight of emerging market investors. While the headlines focus on its $8.5 billion external debt restructuring under the G20 Common Framework, a subtler yet critical dynamic is unfolding in its domestic debt market—one where policy choices have created both risks and opportunities for those willing to parse the granular details. The exclusion of domestic debt from formal restructuring terms, coupled with strict foreign investor participation caps, is reshaping the calculus for frontier market investors. This is a story of hidden vulnerabilities and overlooked assets in a market where every line in the fine print matters.

The Exclusionary Playbook: What's In, What's Out?

Zambia's 2023–2025 debt sustainability analysis (DSA) drew a clear line in the sand: non-guaranteed external debt of state-owned enterprises (SOEs) like ZESCO (the state power company) and domestic-currency debt held by non-residents would remain untouched by the official restructuring process. This exclusionary approach, designed to prioritize external creditor negotiations while shielding domestic financial stability, has profound implications.

The IMF-backed 5% cap on non-resident (NR) participation in primary domestic bond markets, implemented in 2024, has already constrained foreign inflows. By September 2024, NR holdings of domestic bonds had fallen to $2.04 billion (23.9% of total domestic debt), down from $2.2 billion a year prior—a decline fueled partly by currency depreciation and the new restrictions.

The Risks: Liquidity Traps and Contingent Liabilities

The exclusion of domestic debt from restructuring creates two key vulnerabilities:
1. Liquidity Tightness: With the government cutting domestic bond issuance by 3.3% in 2024 (to K232 billion), liquidity in local markets has tightened. This has pushed yields on government securities higher—a double-edged sword. While higher yields attract yield-seeking investors, they also reflect underlying funding strains.

1. SOE Spillover Risks: The non-guaranteed debt of SOEs like ZESCO and Zambia National Building Society ($50 million in 2024 borrowing) sits outside the DSA perimeter. If these entities default, the government could face contingent liability pressure—despite denying explicit guarantees.

The Opportunities: A Discounted Asset Class

Yet, for investors with a stomach for frontier markets, Zambia's domestic debt presents three compelling opportunities:
1. High-Yield Local Currency Bonds: Yields on Zambia's domestic bonds now exceed 15% in some maturities, offering a stark contrast to negative-yielding securities in developed markets. The exclusion from external restructuring means these bonds are insulated from potential defaults on foreign debt.

1. Undervalued NR Positions: The 5% cap has created a “discount” for non-resident investors. With NR holdings now at a decade low relative to total domestic debt, the market's depth is shallow—meaning even small inflows could trigger price rallies.

2. IMF-Backed Stability: The program's success hinges on fiscal discipline and debt transparency. If Zambia avoids a repeat of its 2020 external default, local currency bonds could stabilize, offering asymmetric upside as investor sentiment improves.

The Creditor Dance: IMF vs. Market Realities

The IMF's role here is pivotal. By enforcing the NR cap and pushing for SOE borrowing discipline, it has prioritized debt sustainability over growth—a trade-off that could slow Zambia's economic recovery. Yet, this rigidity also reduces systemic risks, making domestic debt a safer bet than external bonds.

Meanwhile, creditor dynamics are shifting. Foreign institutional investors, now sidelined from primary markets, are turning to secondary trading—driving volatility but also creating arbitrage opportunities. Local banks and pension funds, meanwhile, are filling the liquidity gap, though their appetite is constrained by capital adequacy rules.

Investment Implications: Go Local, But Stay Granular

For emerging market investors, Zambia's experience underscores a critical lesson: frontier markets are not monoliths. The domestic debt market, often overlooked in favor of headline-grabbing external restructurings, is where the real action—and risks—lie.

• Buy the dip in local currency bonds: For long-term investors, Zambia's 15%-plus yields, combined with a depreciating kwacha, offer a potential hedge against inflation and dollar strength.
• Monitor NR participation limits: If the 5% cap is loosened (as some creditors demand), it could unlock a wave of foreign buying—but also increase volatility.
• Avoid SOE debt without guarantees: Until ZESCO and other SOEs demonstrate clear repayment paths, their bonds remain speculative plays.

In the end, Zambia's domestic debt market is a microcosm of frontier investing: high risk, but with rewards for those who parse the details. As the IMF's program enters its final stretch, the next chapter will be written not just in boardroom deals, but in the spreadsheets of local bond traders and the yield curves of a nation trying to balance survival with growth.

Investors should tread carefully—but don't ignore this frontier. The rewards for those who do their homework could be substantial.