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Emerging Markets

Long time passing

Despite its seemingly sound fundamentals, Africa's vulnerability to the global crisis has been laid bare. Much now depends on the direction of the policy response - at home and abroad

Despite its seemingly sound fundamentals, Africa’s vulnerability to the global crisis has been laid bare. Much now depends on the direction of the policy response – at home and abroad.

Sub-Saharan Africa’s vulnerability to the current economic crisis is beyond doubt, not least given the repeated downgrades to the region’s growth forecasts. But for Africa, the bigger question is whether the downturn represents a cyclical setback – or a deeper structural change.

Only recently Africa’s so-called ‘frontier’ markets were widely feted by investors. The region’s economies in recent years had gone through an important turnaround: no longer the laggards of the world economy, from 2001 the region’s growth was outpacing the global average.

The seeds of this change were sown in the aftermath of the Cold War: gradual economic reform, the rolling back of over-extended states and reduced fiscal deficits helped pull inflation down to single digits. Moreover, a widespread shift towards democracy and multiparty politics in a number of countries underpinned the call from African electorates for greater macroeconomic stability.

Many countries were the beneficiaries of debt relief, attracting new portfolio investment as their external balance sheets improved dramatically following HIPC (Heavily Indebted Poor Countries) and MDRI (Multilateral Debt Relief Initiative) forgiveness. Then came China: its rise and the subsequent surge in commodity prices helped boost investor perceptions of Africa’s potential. For decades, African assets had been undervalued, but Chinese trade and investment were seen to have single-handedly reversed this, on the back of what many believed to be a commodities supercycle.

How much has now changed? In many respects, previous investor enthusiasm for African assets – like many emerging markets – had much in common with the factors behind the subprime crisis. A world characterized by strong growth and flush with liquidity led to record capital flows to emerging markets, driving down yields in more conventional investment classes. Global savings imbalances saw the current account surpluses of Asia and the Middle East recycled globally, with flows into US Treasuries helping to keep long-term yields low. Risk appetite was strong, and investors were comfortable moving out further along the risk curve.

Developed markets were typified by their increasing use of leverage to drive returns. High-yielding African markets saw unprecedented inflows, constrained only by the small size of these markets. In many instances, asset securitization could barely keep up with insatiable investor appetite for high-yielding African assets. This was the era of increasing financial innovation, the rise of the ‘originate and distribute’ model, the slicing and dicing of risk.

Slow return

But the world has changed. In the aftermath of the financial crisis, the move away from ‘light touch’ regulation and the costs of the crucial recapitalization of financial institutions, suggest, at the very least, that investor exuberance is not coming back soon. The cost of the heady days of imbalanced growth could weigh down the world for years to come. And while there is increasing talk of a lost decade in the West, for Africa what’s certain is that the days of easy credit are over.

There is money on the sidelines, however. But in today’s risk environment, many investors are primarily concerned about capital preservation. When the ‘green shoots of recovery’ appear and risk appetite picks up, larger emerging markets are likely to benefit before many Sub-Saharan countries. This is partly because the risk of investing in illiquid markets is still fresh in investors’ minds.

Together with high yield, the attraction of frontier Africa was supposed to have been the fact that it wasn’t correlated with the rest of the world. In previous, milder bouts of emerging market contagion, such as May–June 2006, or February 2007, this thesis largely held true. But the belief in non-correlation – which turned Africa into a mainstream investment target – was banished by the financial storm unleashed by Lehman’s bankruptcy.

The problem lay in the extent to which investors who were exposed elsewhere were also long of African assets: investors closed positions in illiquid markets, often moving prices dramatically against themselves. The degree of non-correlation broke down entirely as the old assumptions fell apart. This class of investor is unlikely to return in a hurry.

Pressure from all sides

Downturns rarely favour the vulnerable, and despite the relatively sound fundamentals of many African economies entering the crisis, the rapid withdrawal of liquidity has once again laid bare the risks. Given the still-weak real economic backdrop in much of Sub-Saharan Africa as commodity prices, export earnings – and, in many instances, fiscal revenue – slump, all sources of capital inflows are likely to come under pressure in the near term.

New private portfolio flows have shrunk to only a fraction of prior levels. Longer term FDI (foreign direct investment) in Africa has long been dominated by resources, but with falling commodity prices and a financing crunch to contend with, FDI is unlikely to sustain its recent strength. Estimates suggest that FDI to Sub-Saharan Africa fell sharply by about 21% in 2008, a trend likely to worsen in 2009. While remittances to the region – estimated at $11 billion in 2007 – so far have held up remarkably, the prospect of continued rises in unemployment in the host countries of the African diaspora threatens even this normally robust, counter-cyclical inflow.

Africa will become more reliant on Official Development Assistance in the years ahead, but deep recessions and fiscal deterioration in traditional development partners render improbable the scaling up of aid by rich countries that is required.

As a result, the near-term outlook for African growth is subdued. The IMF cut its growth forecast for the region by 1.8% to 1.7% for this year. Growth in the region will probably rebound to 3.8% in 2010, though still lower than the 5.5% recorded in 2008. Unlike other regions, many African economies are starting from a low base, so should at least see positive growth. But despite a range of stability indicators suggesting limited financial linkages with the rest of the world, the typical narrow economic base of most Sub-Saharan economies means that they are nonetheless vulnerable to the downturn.

Overdependence on commodity exports means that many will see significant widening of their fiscal deficits, with an increasing reliance on domestic, largely short-term borrowing. Whereas elsewhere a comfortable disinflation trend has set in, Africa is already seeing a return of inflation. Whether this turns out to be a short-term influence or is more symptomatic of structural deterioration will depend very much on the policy response. But here, an increasingly mixed picture is developing.

The onset of the financial crisis has already seen a number of countries take a step back from market-based reforms. In Nigeria, pressure on the exchange rate resulted in a move away from interbank determination of the rate, to a more tightly controlled FX regime. Zambia, one of the more liberalized countries in the region has taken steps to tighten the provision of ZMK liquidity to offshore counterparties, making it more difficult to ‘short’ the kwacha. Authorities in Uganda, having once successfully achieved low inflation, have recently boosted domestic currency liquidity, despite inflation still running in double digits. Botswana, long the poster-child for fiscal conservatism in the region with its history of budget surpluses, has announced a budget deficit that could easily exceed -14% of GDP in the current year. Even in South Africa, the central bank continues to cut interest rates aggressively, while surveys of inflation expectations point to inflation remaining above its targeted level in the years to come.

In a crisis, counter-cyclical policy is necessary, but short-term policy developments aimed at providing an immediate boost only count for so much. What matters more is authorities’ ability to return to a more sustainable macroeconomic and policy path once the immediate threat has passed.

New questions

While some countries are experiencing a cyclical slowdown, and a short-term deviation from market-centric policies, in others, a deeper questioning of the ‘Washington Consensus’ is underway. Crisis-hit developed countries are seen to have moved away from market-based principles; why should Africa be any different, or so policy-makers are increasingly asking themselves.

The answer is likely to lie in the future sources of financing. A recent G20 meeting in London reiterated leaders’ commitment to the Gleneagles Principles, while multilateral lenders were called on to make available the funding that African economies now require. A renewed role for the IMF in the region is likely – in time – to halt an apparently renewed tendency to abandon market-centric reforms. But a reopening of market access – itself a function of global developments – will be critical for African countries.

In the future, much as in the past, African economies are likely to remain contested territory. While markets were seen ascendant in the aftermath of the Cold War, resulting finally in a revival of growth in the region, the near term promises to be a greater challenge.

Yet structurally, African economies still have much going for them, including vast, untapped growth potential, and a more positive demographic underpinning to growth than almost any other region. And China’s interests – both long term and strategic – remain.

While there is clearly uncertainty about the near-term trajectory, and evidence of rising economic, regulatory and political risk as the real economy crisis intensifies its grip on the region, today’s optimism surrounding recovery prospects, currently priced in to commodity markets, is almost entirely absent in the African context.

While forward prices for key commodities point to an expected resurgence in price, in Africa there is little recovery priced in. The two observations are mutually contradictory: either there will be a recovery, or not.

Investors, however, should take note, for the best risk-reward opportunities may lie here. African frontier markets are by no means homogenous, but they no longer represent a crowded space.

Razia Khan is regional head of research for Africa at Standard Chartered

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