Africa’s frontier debt markets will bounce back
By Graham Stock | Published: 01 October, 2009
The global financial crisis has taken its toll on Africa in a number of ways. It depressed the prices of key exports, delayed inward foreign direct investment that would have created new jobs and dampened the flow of remittances from migrant workers. It is generally held, however, that the region’s limited integration with the global financial system has been a blessing, keeping the woes of US sub-prime mortgages and over-leveraged investment banks at bay. However, the crisis also interrupted a process of integration for a handful of countries that stood to benefit from a broader range of financing options.
Local debt markets are a valuable alternative to reliance on bank funding or international donor flows. Most developed countries rely solely on their domestic market for such issuance, and their private sectors raise funding there too. Most emerging markets combine their domestic issuance with the occasional offshore bond or loan, particularly to meet needs for hard currency or to diversify their financing sources. In both cases, the investor base consists of local institutions, augmented by similar institutions from other countries. South Africa’s domestic bond market is an established destination for emerging market investors, but other African countries such as Nigeria, Ghana, Egypt, Kenya and Zambia were starting to feature as opportunities.
Various conditions are necessary to attract foreign investors to a new market. Investors need to be confident that the policy framework is sufficiently robust to ensure that prospects for repayment are sound. They are lending the government money on a commercial basis, and need to be sure that default risk is low. The government can demonstrate this by building up a good record of payment to other creditors, and by being as transparent as possible about the health of its balance sheet and budget. The regulatory regime and legal framework also need to be reliable.
Until around the middle of this decade, African governments were rarely able to satisfy these conditions. A few years ago, however, various programs of home-grown reforms started to bear fruit. These reforms were motivated largely by recognition of the need to put their economies on a stable footing, but also by the incentive of debt relief under the Heavily Indebted Poor Countries and then Multilateral Debt Relief Initiative.
The local bond markets in Nigeria and several other countries were already up and running when foreign investors started to take an interest around 2005, motivated not just by a desire to diversify away from more established markets in Latin America, Asia and Emerging Europe, but also by the conviction that the host economies were poised to benefit from greater integration with the global economy, and particularly from rising Asian demand for Africa’s exports. This confidence depended partly on comfort with the institutional framework and policy reforms mentioned above.
The scale of the growth in foreign participation can be seen from data collected by the Emerging Markets Traders Association. Activity by EMTA members in Nigeria’s market, which exceeds all the others put together, may be distorted by trading in the country’s oil warrants, but there is little doubt that the country enjoyed a boom in foreign investor interest over the period.
Investor interest suffered in 2008 due to two factors. The initial flight from African markets was a response to the flight to safety and to liquidity prompted by the financial crises hitting investors’ home markets in the US and Europe. The second factor was a fear that insufficient liquidity existed in the domestic market or the FX market to allow all foreign investors to exit if they wanted to, and therefore there would be a first mover advantage for those who fled immediately.
To ensure that this instinct does not overwhelm the local bond market, regulators should try to make sure that the domestic institutional investor base grows fast enough to remain the dominant player and to provide an underpinning bid to the market. In addition, the central bank may need to soak up incoming portfolio flows in international reserves, which has the additional benefit of preventing a loss of competitiveness for other sectors of the economy through exchange rate appreciation, but then offers a pool of hard currency liquidity that can be made available to smooth the exit of the same flows.
The goal here is not to make life easier for the foreign investor, but to avoid destabilising fluctuations in the exchange rate that imposes costs on the rest of the economy. Those countries that continue to display a consistent and transparent commitment to sound economic policy, and act to reinforce confidence in their market institutions, should quickly see a recovery in foreign investor interest in their domestic bond markets.
Graham Stock is an executive director in emerging markets research at JPMorgan
