It is tempting to see links between increased portfolio investment flows to Africa and May’s emerging market stutter. When foreign investors start buying treasury bills in risky, rarely heard-of African countries, surely the market is overheating and courting a correction?
Not according to investors. Matthew Vogel, head of emerging Europe, Middle East and Africa (EMEA) strategy at Barclays Capital, talks of “sharply improved” perceptions of African capital markets. And Razia Khan, chief economist for Africa at Standard Chartered, describes “very favourable trends” underpinning the new-found appetite for African capital market assets.
Beginning in 2005 and picking up pace this year, portfolio investors have begun to target sub-Saharan African markets (outside of South Africa, which has long-since had actively traded debt and equity markets, and boasts a disproportionately sophisticated financial system). Countries such as Zambia, Botswana and Ghana have all seen a steady (and in Zambia’s case, substantial) rise in portfolio inflows – though still tiny in global emerging market terms.
Why Africa?
Ms Khan cites four factors supporting this trend. First, fiscal policy across the continent has improved, resulting in narrower fiscal deficits and a rise in gross national savings. This has contributed to a gradual slow down in the average rate of inflation, which in turn supports the real exchange rate. Second, rising commodity prices have boosted resource economies, improving these countries’ terms of trade and balance of payments position. Third, debt relief has led to a substantial improvement in the debt sustainability of many African countries, in effect substantially improving their sovereign creditworthiness. Last, but related, Africa’s economy has continued to outperform the world economy and has now chalked up five years of faster growth.
At the same time, excess liquidity has suppressed yields on other emerging market assets. The spread on emerging market debt has dropped to historic lows, with an average of just 306 basis points (bp) in 2005, compared with 423bp in 2004. With investors, and particularly hedge funds, scouring the market for opportunities, interest rates of 14%-25% on six-month to five-year instruments, as in Zambia, have become very attractive.
Appetite grows
Official figures are hard to come by but anecdotal evidence is abundant. “Everyone has been talking about Africa, particularly so since the beginning of this year. These markets have come out of nowhere,” says Andrew Chappell, associate director at London-based broker Exotix.
New-found appetite for African assets is undoubtedly a positive development, signalling both improving fundamentals in these countries as well as growing awareness of the continent’s nascent capital markets. But it is a development tinged with apprehension. Foremost among concerns is that portfolio flows can reverse just as quickly as they materialised. Poor liquidity and the absence of secondary markets can temper volatility but in the event of a wholesale loss of confidence, these markets would soon feel the impact.
What bothers the World Bank is that capital flows to developing countries tend to move pro-cyclically with world commodity prices, increasing when commodity prices are high and decreasing when they are low. The logic is simple: during an upturn commodity prices tend to rise and returns in mature capital markets tend to be lower, causing capital to be pushed to developing countries in pursuit of better returns.
Meanwhile, commodities still account for a large share of developing countries’ exports, meaning an improvement in their terms of trade and real exchange rates when commodity prices rise. As has happened in Africa, this adds to the attractiveness of the market because investors stand to benefit, for instance, not just from attractive interest yields but also the likelihood of real exchange rate appreciation.
Double trouble
As this year’s World Bank’s Global Development Finance report shows, however, when commodity prices fall private capital flows drop sharply – by up to a half, on average. In effect, these countries enjoy a double boost during a commodity boom (better terms of trade and rising private capital flows) but are then hit by a double whammy on the way down. For weak African economies, it can severely exacerbate the effects of economic downturn.
As Mr Vogel notes, attracting attention in a conducive climate when emerging markets are all the rage is one thing, but sustaining investor interest over the longer term is the more pressing challenge. “Debt relief provides a good impulse for interest for many investors,” he says. “Maintaining that interest comes back to policy continuity. Governments and central banks must be sensitive to the drivers of emerging market investment and must understand investment behaviour in their own and regional markets.”
Despite investors recently easing back from emerging markets, Africa’s growth prospects remain sound. With oil prices set to remain high, the continent’s oil-producers are in line for further windfalls. Similarly, sound demand fundamentals for non-oil commodities, from China and India in particular, promise to sustain commodity prices. The IMF forecasts that Africa will grow by 5.3% in 2006. The attractiveness of Africa’s capital markets will continue to improve gradually.
According to Mr Chappell, there is definitely demand for longer-dated instruments. He believes that the opportunity is ripe to accelerate capital market development by issuing new paper, extending the yield curve and providing indicative pricing. It is not so much that African countries need the additional financing – multilateral lenders have committed to providing concessional finance. Rather, it is about strengthening the capital market and providing the platform of private sector players to tap foreign capital.
As the World Bank highlights, however, low-income countries have to balance the potential risks of external borrowing against the benefits. Much of the build-up of debt in the 1980s and 1990s can be explained by weak policy and institutional frameworks, low capacity for debt management, lack of export diversification and limited fiscal revenue capacity.
So is it any different today? In general, African countries are pursuing better macroeconomic policies, indicated by falling inflation (excluding the impact of rising oil prices). And reserves are gradually being accumulated – more rapidly in oil-producing countries such as Nigeria and Angola – cushioning against economic shocks.
Diversification slow
However, other reforms are proving slower to deliver and harder to achieve. Institution-building is complex and difficult. Countries have found it difficult to diversify exports (to hedge themselves against a sharp fall in prices or demand for one commodity), which in turn is a factor of the global trade regime. But African countries have also been slow to break down the barriers to internal trade. And, despite rhetoric about enhancing the investment environment – cutting red tape, fighting corruption and so on – change is not proceeding as quickly as it should.
That is why multilateral lenders are reluctant to see a new round of international borrowing, fearing that some African countries could soon find themselves in an unsustainable debt position.
Mr Chappell also concedes that a brace of issuance is unlikely. “There are many obstacles. There are no benchmarks, there is no credit default swap market and there are very few African corporates [outside South Africa] with the necessary profile to go to the market,” he says.
It is always a mistake to think of Africa as homogeneous. Countries there are clearly at different stages of economic development and have a varying capacity to push along their capital market development. This is why the group of sub-Saharan African countries on investors’ radar screens is only small – South Africa, Nigeria, Zambia, Botswana, Ghana, Kenya, Tanzania, Uganda and some of the CFA-zone countries of west Africa.
There is much to be done to insulate against the capricious nature of foreign portfolio investment, which is why a return to sense in emerging markets – and a slowdown in portfolio flows to Africa – may not be a bad thing.
