Africa takes the development of its local currency bond markets very seriously, not least because it regards them as having a pivotal role to play in addressing the formidable problem of Africa’s creaking and antediluvian infrastructure. To date, much of the revival that has characterised African economies in recent years has been driven by the global commodities boom. Sustainable long term growth, however, will need to be more broad-based. That won’t happen without inward investment on a large scale. And inward investment on any meaningful scale outside the natural resources sector won’t happen without very significant improvements to Africa’s infrastructure.
There is already evidence that infrastructural shortcomings are discouraging and in some instances even preventing much needed FDI inflows. As the African Development Bank (AfDB) observes in a recent report, “international investors in fast-growing African countries are increasingly facing infrastructure bottlenecks. In Mozambique, for example, transport, power and other deficiencies have caused large industrials such as Rio Tinto to write down the value of investments.”
The AfDB’s exhaustive study on African infrastructure reports that the continent will need to invest $68bn between now and 2020. This is based on the assumption that Africa grows at 6% a year between now and 2040, lifting per capita income over the same period to more than $10,000 across the continent.
If Africa is to expand at this rate on a sustainable basis, it will need to meet an increase in power demand from 590TWh in 2010 to over 3,100TWh by 2040, increasing capacity from 125GW today to almost 700GW by 2040. It will need to cater to transport volumes that will increase by between six and eight times (considerably higher in some of Africa’s landlocked countries). And it will have to upgrade its ports to make them capable of handling over 2bn tonnes of freight by 2040, compared with less than 300m today.
According to the AfDB, the sources Africa has available now amount to approximately $30bn. That leaves a shortfall of $38bn. Some of this will be plugged by bank finance, export credit agencies, funding generated through privatisation and foreign direct investment. Some will also be met through issuance in the international capital markets, which have been increasingly receptive to African sovereign borrowers over the last 18-24 months.
One striking example came in April 2103, when Rwanda launched its debut bond in the international capital markets. The order book for this 10 year $400m bond, led by BNP Paribas and Citi, reached $3.5bn, more than half of Rwanda’s GDP of $6.9bn.
Although opportunities for new issuance from emerging market sovereigns have been restricted in the wake of concerns over when the US Federal Reserve might begin to reduce its bond buying programme, the long term prognosis is for more African sovereigns to harness international demand for exposure to the region. As Moody’s comments in a recent piece on African sovereign debt ratings, the agency also believes more issuance will lead to “the wider participation of local governments, corporates and financial institutions in international debt capital markets.”
While the response to issuance has been an important vote of confidence in Africa’s economic prospects, hard currency deals leave borrowers exposed to currency risk and do little to foster the development of domestic capital markets. And with issuance windows for EM borrowers opening and shutting in line with capricious international sentiment, funding through the Eurobond market is also potentially hostage to execution risk.
That is why a growing number of African governments are hopeful that an increasingly meaningful proportion of the necessary funding will also come from local capital markets. That, in turn, is why the AfDB is committed to supporting the development of capital markets across Africa by issuing in local currencies. “More and more, clients are coming to us with projects that are generating local currency revenues,” explains Max Magor Ndiaye, principal treasury officer at the AfDB. “It’s the role of the AfDB to help those clients reduce their exposure to foreign exchange risk by providing matched funding in local currency.
“At the same time, it is important for the AfDB to help to stretch the yield curve in local currency markets, where local banks’ funding is very seldom available beyond four or five years,” says Ndiaye. “So our additional role in local currency markets is to establish new benchmarks and to provide role model transactions in terms of execution and distribution. We’ve been doing this for many years in the South African rand market, but more recently we have also supported the expansion of a number of other local currency markets.”
A notable recent example has been the AfDB’s issuance in Uganda, where the bank set up a 125bn Ugandan shilling medium term note (MTN) programme in July 2012. The first issue from this shelf was a 10 year, Sh12.5bn bond (about $5m), which was described by the AfDB at the time as a landmark issue. This was because, unlike its previous bonds linked to African currencies, all coupon and principal payments are made in shillings, with no currency swap attached to the transaction. AfDB followed up on its pledge to be a regular issuer in the Ugandan shilling market in May 2013, with another transaction with the same size and maturity.
Pricing on both deals adopted the same formula, with the coupon set at 85% of the yield on the two year Ugandan government bond. “Because the local currency proceeds are on-lent to local businesses, an important aspect of our strategy is that we leverage our triple-A rating to fund at the best possible price for the client,” he says. “In the case of the Ugandan shilling issue, we priced at about 200bp below the government curve.”
Ndiaye says that AfDB is now setting up a similar MTN programme in the Nigerian naira market and is planning similar initiatives in Zambia, Ghana, Tanzania and Kenya.
Pension funds under-resourced
To date, AfDB has placed all its Ugandan shilling issuance with local investors. That is in line with AfDB’s objective in local currency markets, which is to promote the growth of market infrastructure in some of the less developed African markets. Distributing its bonds locally also meets AfDB’s aim of helping to support the expansion of the domestic institutional investor base in general, and pension fund participation in particular.
Although they are growing rapidly, pension funds across the continent remain woefully under-resourced. According to the AfDB, aggregated pension fund assets in its eight target markets now amount to $40bn, compared with $320bn in South Africa alone. That leaves banks to take up much of the supply in the local currency markets, which in turn explains why demand has been concentrated chiefly at the short end of the curve.
Ndiaye says, however, that AfDB also aims to support the growth of local currency capital markets by placing bonds internationally. “Ideally, we’re looking to attract a combination of domestic and international investors, because we recognise that by bringing in overseas investors we can lower pricing,” he says. “Much of the proceeds are used to finance local infrastructure projects in Africa. The lower the cost of our local currency funding, the better it is for the country concerned.”
Ndiaye acknowledges, however, that the small size of AfDB’s Ugandan shilling transaction made international participation impractical. “One of the challenges we face is to attract foreign investment into relatively illiquid markets,” he says. “Our Nigerian and Zambian programmes, however, will be for as much as $1bn and $500m, and we are talking to a number of international banks about developing ways of encouraging international investors to take part.”
Another initiative that the AfDB is now undertaking with a view to making African markets more investable, Ndiaye says, is the creation of the African Domestic Bond Fund (ADBF) that will invest in African local currency denominated sovereign and state guaranteed sub-sovereign bonds.
“It is envisaged that the ADBF will be an index tracker fund,” he explains. “Therefore the scope of this project also includes the development of the African Domestic Bond Index (ADBI) as the benchmark that will be replicated by the ADBF as far as possible in order to generate returns closely correlated to the ADBI while maintaining a similar risk profile.”
The ADBI is being constructed as part of the African Financial Market Initiative (AFMI) and includes bonds listed in seven countries — Botswana, Egypt, Ghana, Kenya, Namibia,
Nigeria and South Africa.
Bankers are confident that over the longer term international investors will play an increasingly active role in Africa’s local currency markets. “I definitely see more demand from international investors for a number of reasons,” says Florian Hartig, global head of debt capital markets at Standard Bank. “First, because international understanding of African credit has improved dramatically in recent years. Five years ago, smaller local currency markets like Zambia and Tanzania often didn’t appear on research analysts’ radar screens. Today, they are as well-informed about these markets as they are about the largest economies such as Nigeria and South Africa.”
The second reason Hartig gives for his optimism about the prospects for African debt markets is the growth outlook. “We’re very bullish on Africa, where we have seen average annual growth of between 5% and 7% over the last few years,” he says. “We believe there will continue to be similar growth in the years ahead.”
A third is the palpable interest that international investors have shown in African local currency Eurobonds issued by top-rated supranational and agency borrowers. “I know these are different from local debt in that they have different ratings and prospectus and listing requirements, but they are an important first step because they give investors access to the yield curve in local currencies,” he says. “Already, we are seeing signs that international investors’ appetite for local currency as well as local credit risk is rising. For example, we are seeing an ever-increasing uptake by international investors in Nigerian government bond auctions, among other local currency markets.”
Another reason why analysts believe African local currency debt may become increasingly popular as and when the current bout of unease about emerging markets passes is its relatively low correlation with other comparable asset classes. According to research published recently by Standard Bank, “while Africa’s Eurobonds remain correlated to the rest of EM, African FX, local bonds and equities remain relatively uncorrelated, potentially offering outperformance during the present profit-taking.”