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Analysis & opinionJanuary 2 2019

Nikhil Rathi: Capital markets development is key to Africa’s growth

Only by developing its local capital markets can Africa gain access to global investment, which would enable the continent's countries to combat climate change, build infrastructure and support its wide range of companies, says London Stock Exchange CEO Nikhil Rathi.
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Nikhil Rathi

It was 80 years ago when the first African company listed on London Stock Exchange; today there are 110 listed in London, with a market capitalisation of nearly $200bn. 

Over the past three years London Stock Exchange Group’s Africa advisory group, a body of distinguished African thought leaders, has worked with decision makers, regulators and businesses across the African continent, looking at how to increase global investment flows and create deep and sustainable capital markets for Africa. 

African countries have experienced strong gross domestic product (GDP) growth over the past two decades. For the continent to sustain this long-term growth trajectory, substantial investment is required. Through our research and engagement we found common themes that are key to enabling this investment, but we also recognise that the needs will differ between the continent’s 54 countries.

Green bond markets

The UN Environment Programme has identified Africa as the continent that will be the most severely affected by climate change. Climate-related damage, as a percentage of GDP, is projected to be higher than in any other region in the world and twice as high as in Europe, Asia and the Americas.

The cost to invest in necessary infrastructure to combat climate change is projected to be between $20bn and $30bn annually through to 2030. To meet this funding challenge, African countries will need developed green financial markets.

Green bonds have been growing in popularity globally, reaching $155bn in 2017, and nearly doubling each of the past several years. As of mid-December 2018, there were 94 green bonds listed on London Stock Exchange, the first global exchange to create a dedicated green bond segment. In 2017, Nigeria became the first country in Africa to issue a sovereign green bond (and only the fourth in the world). Institutions in South Africa have also issued green bonds, and some other countries are beginning to recognise the potential, but there is more work to be done. 

Clear and globally recognised green bond principles are needed to support the development of green bond markets and enable inflows of private sector investment. A green bond segment and green listing rules, such as have been launched in South Africa, enable transparency and help raise awareness by issuers and investors. At the same time, the issuance of sovereign (or multilateral development bank) green bonds will help lead the way, by establishing a yield curve across multiple maturities to support further issuances by corporates. 

In 2015, London Stock Exchange became the first major exchange to launch a dedicated green bond segment. As well as green bonds there are 70 listed green companies with a combined market cap of $94bn in London, including 14 renewable investment funds. In May 2018, London Stock Exchange welcomed Gore Street Energy Storage Fund, the world’s first listed energy storage fund.

Passive investment flows

For the past 16 years, African countries have outperformed the global average GDP growth by about two percentage points annually. To continue that growth, countries across the continent will need increasing investment. Attracting passive investment funds is key to supporting this continued strong growth.

As of March 2018, assets under management in exchange-traded funds (ETFs) and exchange-traded products globally stood at $4900bn, but passive investment flows into Africa have been relatively low, with only 7.5% of the global total.

The classification of markets by index providers is a major step in the process of index construction, and the addition of more African companies into indices would be instrumental in encouraging more investor flows into the region. At present, 10 countries in Africa are currently classified by index provider FTSE Russell, part of London Stock Exchange Group. Egypt and South Africa are classified as ‘emerging’, with South Africa accounting for 75% of Africa’s share of global passive investment inflows.

There are eight frontier markets on the African continent, with the remaining 44 African countries ‘unclassified’, meaning that 80% of Africa’s countries are not included in any of the global passive flows tracking frontier or emerging markets.

If an African country were in the 'emerging' classification, it could potentially have access to $1500bn of equity assets under benchmark tracking emerging markets indices. This does not take into account the potential country- and region-specific ETFs that could be launched. As an example, following the announcement that China A Shares would be included in emerging markets indices, HSBC issued a China A Shares ETF in July 2018. This was a reflection of the long-term reforms that had been implemented to develop China’s capital markets.

Aside from the direct impact of passive funds, country classification also tends to have wider effects on a domestic market. In fulfilling the criteria for better functioning of the markets, local capital markets develop, leading to increased domestic activity, more issuances and stronger local investor participation. All of this leads to improved financing of a country’s economy.

Filling the investment deficit

Despite strong investment appetite and improvements in access to domestic and international markets, the size of infrastructure investment required in Africa significantly exceeds the sums that domestic capital markets are currently able to provide.

This has resulted in an estimated investment deficit of $93bn per year. African countries now also look at financing internationally. We have seen a flurry of issuances of African sovereign Eurobonds on international markets and the consistent oversubscription of these offers.  

However, one potential problem with raising capital on international markets is currency exposure. Borrowing in a non-local currency to fund projects that are financed and generate returns in the local currency create currency and other macro-prudential risks for the issuer. As we saw in the Asian financial crisis of 1997, as the US dollar appreciates and the cost of servicing dollar debt increases, borrowers have to post more domestic currency as collateral. This inflates debt levels, which in the context of lower growth and credit downgrades further increases the exposure and vulnerabilities of these economies.

One solution that has been gaining significant traction involves raising debt finance offshore in local currencies, creating an ecosystem that develops a country’s offshore local currency bond market. The African Development Bank issued its first offshore naira bond in 2007, with 100% participation, 52% of which was from the US, and 77.9% was from fund and asset managers. 

More recently, in 2018 Quantum Terminals Group, a leading private sector energy infrastructure developer in Ghana, issued the country’s first offshore cedi-denominated bond on London Stock Exchange. The issuance was supported by Guarantco, which is part of the Private Infrastructure Development Group and works to mobilise private sector local currency investment for infrastructure projects.

Offshore local currency bonds offer the potential to raise capital in local currencies from a global investor base. The international investor gets access to higher yield securities by taking on the currency risk and the issuer has potentially lower costs than raising capital in onshore markets or bank financing.

Supporting SMEs

Small and medium-sized enterprises (SMEs) are often referred to as the engines for economic development and job creation. In Africa, SMEs account for about 90% of businesses – but many experience a shortage of finance at all levels, estimated to total $140bn. Ultimately, the lack of funding can result in millions of SMEs being forced out of business, preventing these vital enterprises from reaching their full growth potential and becoming the ‘blue chips’ of the future.

One reason that SMEs do not get sufficient financing is a lack of awareness of the variety of financing options available. Traditionally, SMEs in African countries have relied on short-term debt to finance their operations. This strategy can result in high-growth businesses prioritising loan repayments rather than funding their growth.

Internationally recognised training programmes, such as London Stock Exchange Group’s Elite, as well as regional SME hubs, helps educate entrepreneurs and build the skills and connections SMEs need to access more diverse funding options. Elite first launched in Africa in Morocco in 2016 in partnership with Casablanca Stock Exchange, followed by west Africa in partnership with Bourse Régionale des Valeurs Mobilières, and is exploring a launch in Kenya with the Nairobi Stock Exchange.

From microfinance and angel investing to venture capital, private equity and potential listings on growth segments of local stock exchanges, SMEs need to be supported with access to the full range of financing options. Some companies are too big for microfinance, but may not be ready for conventional debt and equity investors. An SME growth segment, on local exchanges, supported by an ecosystem of SME-focused banks and investors, could fill this gap on the funding ladder giving more companies the opportunity to reach their full potential.

Developing deep and sustainable capital markets are the best way to support Africa’s continued strong growth. Through the development of local markets, Africa’s economies can tap into global investment to combat the effects of climate change, meet its vast infrastructure needs, and support its diverse ecosystem of corporates at every stage of development from start-up to blue chip.

Nikhil Rathi is CEO of London Stock Exchange plc, and director of international development at the London Stock Exchange Group.

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