African currencies gain favour

South Africa dominates Africa’s foreign exchange (FX) markets. Daily turnover of the rand, one of the most heavily traded emerging market currencies, amounts to almost $10bn. No other African country comes close to this. Egypt, the next largest FX hub, has a turnover of between $200m and $400m each day. In Nigeria and Kenya, daily volumes lie between $100m and $200m.

But despite this, African currencies are currently in vogue with the world’s investors. “There’s a huge amount of interest in them,” says Andrew Daley, managing director, global markets, at Standard Bank.

Real money

This marks a turnaround from the height of the financial crisis, when investors were withdrawing money from Africa in droves. Today’s inflows are still lower than in 2006 and early 2007, says Stuart Culverhouse, global head of research at Exotix, a boutique investment bank specialising in frontier markets. But they are increasing quickly.

Some also argue that these flows are less volatile than before. “In the initial wave of interest in 2006, hedge funds were at the forefront,” says Razia Khan, head of African research at Standard Chartered. “Much of that had to do with the amount of leverage being extended by the banks. Now we see a lot more real money investments in Africa.”

High growth rates are the root cause of the new-found demand. Economic activity in north Africa has slowed this year following the revolutions in Egypt, Libya and Tunisia. But gross domestic product (GDP) in sub-Saharan African is expected to increase 6% in real terms both this year and in 2012.

Among the currencies most sought after since the start of 2011 have been the Nigerian naira, the Ghanaian cedi and the Zambian kwacha. Bankers say that is no surprise given that these are some of the continent’s fastest growing economies.

Thanks to the fundamentals 

Africa’s rapid growth has generally been accompanied by stronger fiscal positions and greater monetary stability. “The economic fundamentals drive the interest [among FX investors],” says Mike Christelis, head of Africa trading at Absa Capital, a subsidiary of Barclays. “The African story is getting better. There are still some disturbances. But governance and economic management are improving. Inflation rates tend to be lower than before.”

Much of the interest in African currencies is coming from companies making foreign direct investments (FDI) on the continent. They have been attracted by Africa’s largely untapped consumer markets and growing middle class.

Corporate investments have not only helped strengthen African currencies, but they have also led to a diversification of FX products. Until three years ago, almost all African currency trading outside South Africa took place on spot markets. But companies increasingly want to manage their FX and interest rate risks by hedging them. “In some regions we are doing quite a few FX options and we are starting to see more cross-currency swaps and local currency interest rate swaps,” says Mr Christelis. “These are rolling out, albeit slowly.”

Attractive yields

Asset managers are also increasingly keen to gain exposure to African currencies, many having enlarged their allocations to the continent in the past two years. They have mostly targeted fixed-income assets, rather than equities. This is in large part thanks to the high real interest rates on offer in domestic government bond markets.

“African equities are still quite weak,” says Exotix's Mr Culverhouse. “But investors can come into government debt markets and get 12% to 13% yields while still experiencing currency stability.”

The yields are particularly attractive when taking into account the recent stability of many sub-Saharan African currencies. Most have moved in a narrow band of 1% to 3% since the start of August, despite global equity markets plummeting in this time (east African currencies, which have depreciated heavily this year, are an exception).

Ghana is a case in point. Its one-year local sovereign debt yields about 11%, while the five-year part of the curve trades at 14.25%. Yet the cedi has been broadly unchanged versus the US dollar this year.

Demand for local currency bonds has also been fuelled by the increase in Eurobond issuance from African sovereigns – Côte d’Ivoire, Gabon, Ghana, Nigeria and Senegal have all printed deals in the past few years. This has raised the profile of African issuers and caused investors in offshore bonds to look at the other investment opportunities available, onshore debt being one of them.

African governments have generally liberalised their FX and capital controls in the past decade, which has been key to enticing investors to take on local currency exposure. Ghana, Kenya, Nigeria, Uganda and Zambia – the biggest sub-Saharan bond and FX markets – all have freely convertible currencies.

Right balance

Even in these countries, however, some restrictions remain as far as capital markets are concerned. In Ghana, foreigners can only participate in government bond auctions of three and five years, the longest tenors on offer.

Yet, most African countries are liberalising regulations in their bond and equity markets as they seek to attract foreign investment. For example, in July, Nigeria lifted a rule requiring non-residents buying local government bonds to hold them for at least a year. This has had a big effect on investors’ willingness to take on naira exposure. “We’ve seen a dramatic increase in the number of enquiries [about Nigerian government bonds] subsequent to that,” says Mr Christelis.

Bankers point out, however, that African governments should not blindly liberalise their FX and capital markets. A case in point is Tanzania, where investors are keen to get more access given its strong growth and its recently discovered natural gas reserves, which are so large that it is soon expected to be one of the world’s biggest exporters of the commodity.

The country places far more restrictions on foreigners buying local currency bonds and equities than its east African neighbours, Kenya and Uganda. Some say it is right to move cautiously, as rapid flows into its small economy could cause asset bubbles. “African governments are taking prudent incremental steps,” says Standard Bank’s Mr Daley. “A big bang approach is highly risky.”

Appetite for Angola

A country that several Africa-focused investors crave exposure to is Angola. Its economy is being propelled by the production of 2 million barrels of oil a day (making it, along with Nigeria, the continent’s biggest crude exporter). Yet, the country has no stock market, no corporate bond market and severely limits foreigners’ ability to hold local currency government debt (the market for which, in any case, is very small). Moreover, the kwanza is not freely traded. “There’s a lot of interest in Angola, but getting access to it is pretty difficult,” says Mr Culverhouse. “Working out how to meet that interest is not always a possibility. Or if it is, it will be prohibitively expensive.”

Angola is planning to open up, but changes are happening slowly. Officials first talked of a stock market in 2006, but still seem some way from launching an exchange.

Part of the reason is that Angola’s economy, being heavily dependent on oil, is highly dollarised, with little lending taking place in kwanzas, even through local banks. Furthermore, while oil prices remain high, there is no great need for the sovereign to try and raise more debt by enticing foreigners to buy its bonds (the country is forecast to have a fiscal surplus equivalent to 8% of its GDP this year).

On the down side 

Not all African currencies are in demand, however. The Kenyan and Ugandan shillings have been among the world’s worst performers this year, the latter depreciating more than 20% against the dollar. The two countries should grow between 4% and 4.5% in real terms in 2011, but both are suffering from high inflation, partly owing to the rising price of energy and food imports.

Inflation climbed in Uganda from about 1% in October 2010 to 19% in August 2011. Kenya, which investors have criticised for not upping interest rates quickly enough, saw inflation rise from 3% to 16% in that period. “The inflation situation has deteriorated tremendously,” says Absa Capital’s Ridle Markus, an Africa economist. “So the currencies in the region look a lot less attractive for financial market investors.”

The weakness of east Africa’s currencies shows that liberal FX and capital market regimes are not enough to attract foreign investors. Instead, economic fundamentals are what will decide whether or not they take on local currency risk.

Over the next 10 to 20 years, those fundamentals look good for most African countries. “For a lot of them, we’re looking at very high growth rates, improvements to their external accounts, strong FDI flows and improved macroeconomic management,” says Yvette Babb, an Africa currency strategist at Standard Bank.

If this turns out to be correct, FX investors are unlikely to pass on the opportunities that will result.