Exploring Africa

IFR IMF Special Report 2011
13 min read

For years investors have enthused about the potential of Africa. But while the proliferation of Africa funds demonstrates an appetite for exposure to the region, the development of its capital markets has been frustratingly slow, with the financial crisis only exacerbating the issue. Will it be worth the wait?

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Watching African capital markets mature is a pastime that requires considerable patience. However, while change may not be as rapid as some would like, there are signs of improvement. “Corporate governance is improving, and the difference is quite striking if you compare it with 10 years ago,” said Clifford Sacks, Africa CEO at Renaissance Capital.

“Countries such as Zimbabwe have progressed to the point that Essar had the confidence to make an offer for Zisco – one of the the biggest deals the country has seen since independence.”

That the flows are relatively meagre relative to some previous expectations probably demonstrates the unrealistic nature of those expectations. Neither did the financial crisis help frontier markets, which have not benefited from the structural shift towards emerging markets and away from the West in recent years.

Many hedge funds and other investors that would be the natural leaders of the move into frontier markets made significant losses on their illiquid investments in 2008 and are still nervous about any investment that might be hard to exit if the market turns.

Often precarious political situations are a particular hazard in Africa, while rapid urbanisation is putting a strain on already threadbare infrastructure systems, creating the most significant constraint on growth in the region. Governments are keen to address the situation.

Traditionally infrastructure investment has been supported by aid but the capital required outstrips supply. Chinese investment in infrastructure is increasingly important, though the importance of this funding avenue is often overestimated, according to Stephen Bailey-Smith, head of African research at Standard Bank, with some headline-grabbing deals failing to materialise. Neither is China the only source of finance outside the West: both India and the Middle East have made significant investments in African infrastructure projects.

Cheap European assets divert attention

For many investors, however, attention has been diverted from Africa by a glut of underpriced assets in Europe. Some investment grade assets have traded at a discount to African equivalents. And while many thought 2010 would be the year the continent’s fortunes picked up again, the depth and severity of the crisis means risk sentiment has taken longer than expected to normalise.

However, with Africa on average now trading inside PIG levels, global market flows look to have entered a new, healthier paradigm, said Bailey-Smith.

Africa is dominated by South Africa, Nigeria and Egypt, with Kenya and Ghana comprising a second, considerably smaller tier. This concentration is mirrored within African counties, where the markets tend to be dominated by a small number of very big firms – which are often listed outside Africa.

Very few African corporates are big enough to issue paper, while only around 10 to 20 of the biggest corporates from each country – usually mining companies or financial groups – are big enough to tap the syndicated loan market.

Although Africa is often viewed as an extension of the commodities story, and many of the most well-known African companies are resources concerns, there is little correlation between the sophistication of African markets and mineral wealth.

Two of the most sophisticated African markets are found in Kenya and Cote d’Ivoire – two countries with little commodity wealth. Mauritius, another small country that relies heavily on imports to make up for its lack of natural resources, also boasts a strong and diverse economy. Conversely, resource-rich countries such as Congo, Liberia and Sierra Leone have often been hostage to civil war and corruption, while even Nigeria’s financial sophistication is not matched by its commodity reserves.

In the north of the continent, the revolutionary developments of the “Arab Spring” have been bittersweet for the region’s capital markets. While the insurrections have given hope for the people of North Africa and beyond, for democracy and with it the greater economic prosperity and market confidence that should follow, the near-term impact has been disruptive.

Figures from the United Nations Conference on Trade and Development’s World Investment Report 2011 show foreign investors are avoiding Africa. The trend started following a peak at more than US$70bn in 2008, though North Africa peaked the previous year at about US$25bn. FDI inflows to Africa for 2010 came to US$55bn, 10% of total FDI to emerging markets, with a third of that going to the north.

But the revolutions are certainly having an impact. Egypt, which saw inflows of US$6.3bn, witnessed an 80% fall year on year in the first four months of the year. It is reasonable to expect similar falls in other countries, with Libya having seen FDI inflows of US$3.8bn in 2010 and Tunisia taking in US$1.5bn.

West Africa, which saw US$11bn FDI inflows, was also hit, this time due to regulatory concerns in the oil industry, UNCTAD said, though a 29% fall in Nigeria was partly offset by inflows of US$2.5bn to Ghana and US$947m to Niger.

Sharing the wealth

Despite its upheavals, investors still have an appetite for African businesses, and not just its numerous commodity giants. Investors are waking up to the potential of African consumer stocks, though it remains a difficult and risky sector.

Western companies such as Walmart are looking to cash in on Africa’s emergence, but there is a lot of Greenfield build out too, said Sacks. This has principally occurred in countries that have shown signs of growth and development in other sectors already, but not exclusively so. On London’s AIM market, Zambeef, a consumer and agribusiness concern, recently became the first Zambian corporate to list internationally in a generation.

In recent years emerging markets have been net providers of capital, with developed economies net borrowers. Now asset flows seem to be entering a healthier phase where developed economies are no longer sucking capital out of emerging markets, and capital is instead flowing away from wealth bases in the west, to high-growth markets including Africa.

Although adjusting to this will be difficult for Europe and the US, facilitating a period of sluggish economic activity, it is good news for emerging markets, which will experience strong growth. Within 10 years global growth will be split approximately 50–50 between developed and emerging economies, predicted Bailey-Smith, from a two-thirds to one-third split now. “The outperformance of emerging markets will ultimately contribute to make the global financial system more stable,” he said.

So far Africa’s growth has been driven principally by domestic populations, yet their opportunities to invest in their own economies have been strictly limited. Until the recent listing of First Quantum, no mining stocks were listed in Zambia, despite the sector dominating the country’s economy. In many other countries there is still no access to the major companies and sectors of those countries, which prefer to list abroad.

Things are gradually changing, with a growing number of companies now eyeing domestic listings – though given the limited liquidity and capital available on African exchanges outside South Africa these will usually run alongside foreign listings.

Despite its upheavals, investors still have an appetite for African businesses, and not just its numerous commodity giants. Investors are waking up to the potential of African consumer stocks, though it remains a difficult and risky sector

Progress will be slow. Fierce competition among smaller exchanges cannibalises what liquidity there is and there is little prospect of co-operation to form a regional hub that could deliver reduced costs and better liquidity, because the cultural differences and regional pride are too strong, said Sacks. However, exchanges are likely to see incremental growth across the region, he added.

Governments need to do more to encourage and accelerate improvements in the equity market, said Hasnen Varawalla, head of new markets investment banking at Renaissance Capital. They need to instill an equity culture as a means of saving, entice companies to list and find ways to generate liquidity on domestic exchanges.

One of the most effective steps governments can take is to encourage domestic pension funds to invest more capital in locally listed companies, as Poland did, Varawalla added.

Besides that governments must invest in regulation, custody and settlement infrastructure to support those companies that do decide to list locally. “The experience of Rwanda, demonstrates what is possible: it has seen two corporates – Bank Kigali and Bralirwa – list exclusively in Rwanda, where there has been strong international investor interest and solutions for custody and settlement have been found,” said Varawalla.

Growing up quickly

The debt markets are developing quicker than the equity markets in Africa. Retail investors are more familiar with, and significantly more likely to participate in, local government debt or local currency debt of big local corporates. But there is still more work to be done. “Savings need a channel,” said Varawalla. “Bank deposit rates are negative in real terms because inflation is high, so money naturally flows to less productive assets like real estate.”

Africa has seen a wave of Eurobonds launched from countries such as Egypt, Tunisia and Morocco, as well as from Sub-Saharan Africa in Senegal, Cote d’Ivoire, Ghana, Gabon and Nigeria. The number of countries issuing Eurobonds is set to double within the next 12 months, according to Bailey-Smith.

Zambia, Angola, Namibia, Uganda, Tanzania, Kenya and Mozambique are among the countries eyeing deals – mainly to finance infrastructure improvements and for deficit financing, where dollars make more sense than local currencies.

But while Eurobond deals have been useful to build relationships with real money accounts, most African governments usually find local currency preferable, and such deals still hugely outnumber Eurobond deals.

African countries are increasingly moving towards issuing such deals where possible, thereby avoiding an asset-liability mismatch. By building a local currency curve, the sovereign also paves the way for corporates to issue their own deals, reducing their reliance on more expensive bank financing.

Within the next 10 years this will filter down to the medium size companies, which will in due course gain access to financing from local banks, though this is usually still hard to obtain, said Bailey-Smith. But the outlook remains bleak for SMEs, for which even access to bank financing remains some way off.

Because African countries have such a great need for capital their markets are developing faster than was seen previously in Asia. Nigeria, for example, has developed rapidly from having almost no issuance four years ago to having a deep, 20-year curve.

But there remain practical obstacles to further development. For example, African countries have a tendency to issue separate deals every time they come to market, instead of retapping benchmark bonds. A retap can be the better route because it generates secondary market liquidity, which in turn encourages more primary market participation from accounts that do not necessarily want to be stuck holding a bond until maturity.

Nigeria and Egypt have already issued benchmarks and other countries are sure to follow once the benefits of the approach have been recognised, said Bailey-Smith.

Bailey-Smith believes the decision some African countries have taken have inhibited capital market development, for example the listing of some countries’ bonds on exchanges. And he described the measure some have taken to tax bond issues as “ridiculous”, reducing the incentive for private investors to finance government activity. The measure is revenue neutral, as governments need to offset this disincentive by increasing the yield on the deal, he said, while subjecting the deals to capital gains tax also makes it impossible for the transactions to be benchmarked.

“Taxing bond market activity is definitely the most stupid thing a lot of African governments do,” said Bailey-Smith. The positive element to this is there are still plenty of low-hanging fruit for African countries to pick in improving their capital markets.