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AFRICAN INVESTMENT: For whom the bell tolls

By Sid Verma
24 May 2010

Africa’s biggest selling point remains its unrealized potential. But capital inflows are likely to remain weighed down by the region’s still weak and illiquid capital markets

For a time, it seemed the global financial crisis had ripped apart the investment case for frontier markets. As the cost of capital surged, a consensus began to emerge that a post-bubble era would usher in a smaller global financial economy, where risk aversion would confine mainstream investors to more liquid, efficient markets at the expense of higher risk economies.

The more developed emerging markets in Asia, Latin America, Russia and the Gulf are being hailed as the new safe havens. Thanks to higher growth and strong economic fundamentals in these markets, asset prices have, in many cases, returned to pre-crisis levels.

Indeed the rationale for emerging market investment has never been more compelling. The structural weakness of western economies – with their huge debt burdens, ageing populations and weak banking systems – has increased the strength of emerging economies.

By contrast, the outlook for frontier markets is less clear. Even with near-zero interest rates in the developed world, the MSCI frontier markets index has underperformed the MSCI’s emerging markets index by 27% since March 2009. And the frontier index still stands at around half its peak in the 2007 bull run.

After outperforming between 2003 and mid-2008, frontier markets have underperformed developed bourses since the onset of the crisis. “In terms of attracting foreign capital in the last year, it’s not a great story for sub-Saharan Africa,” says Matthew Pearson, head of African equity products at Standard Bank.

As a result, the global crisis has undermined two reasons for investing in frontier markets: first, the higher returns, due to the higher risk, and second, their non-correlation with the developed world – a claim that took a hit when exotic stock and bond markets collapsed in 2008.

The global crisis showed the dangers of investing in illiquid markets with weak regulatory regimes and poor market infrastructure – in the grip of the crisis, the wave of forced selling triggered a self-reinforcing collapse in asset prices. Investors exiting frontier markets “merely exacerbated its illiquidity”, says Razia Khan, chief Africa economist at Standard Chartered.

Sub-Saharan Africa, with the exception of South Africa, fits the conventional picture of frontier markets. On the face of it, the region is blighted with volatile political regimes, small and illiquid markets and opaque – or corrupt – business practices. For example, the Nigerian stockmarket – reckoned one of the best frontier markets in the bull run – slumped 34% in 2009 to become the world’s second-worst performer after Ghana.

The Nigerian banking system, which makes up at least 40% of the value of the country’s exchange, buckled under bad debts, triggered by poor risk management, which was laid bare by the crisis. But thanks to a government bailout of the banks, the Nigerian Stock Exchange All Share index has surged 27% this year, outperforming a 9.5% gain in the Morgan Stanley frontier markets index over the same period.

Although inflows have yet to rebound to pre-crisis levels, there are signs that portfolio investment into sub-Saharan Africa is back in fashion. Foreign banks, since last summer, are returning to the region. Sovereign capital-raising also shows how the region’s access to international finance is gradually diversifying away from traditional bank lending and foreign direct investment. Senegal, for example, issued its first international bond in December 2009, and Seychelles concluded a successful debt exchange operation in February 2010.

But the pace of debt issuance elsewhere has been slow. Kenya, Mozambique, Nigeria and Tanzania – all potential issuers – are reluctant to pay the heavy premiums on debut issuers from frontier markets.

Earlier this month, Angola suspended its plan to issue up to $4 billion in international markets. Instead, the finance ministry said it would issue debt domestically to help finance government spending.

For specialized investors, choosing African equity is almost a no brainer. Frontier equities are trading at around 10 times prospective earnings compared with 16 times for emerging markets, according to Citigroup.

Antoine van Agtmael, chairman of Emerging Markets Management, which oversees up to $14 billion of stocks globally, says: “We now have an anti-Bric [Brazil, Russia, India, China] bias and are stepping up exposures to Africa – where the real value lies.”

Mark Mobius, executive chairman at Templeton Asset Management says: “Africa’s strong growth potential contrasts with the developed world, while Asian and Latin American markets are now fairly valued. As a result, frontier markets are where investors need to be to outperform in the coming years.” He tips Nigerian banks and Kenyan consumer stocks.


The regional recovery will trigger a market rally as investment, consumption and trade pick up, he says. The IMF estimates that economic growth in the region will reach 4.7% this year and 5.9% in 2011, compared with 2.1% last year, which was impressive, given the severity of the global downturn. This year, exports are driving the growth recovery, while strong harvests are boosting rural incomes, and “the rebound in commodity prices has buoyed fiscal and trade balances,” says David Cowan, Africa economist at Citigroup.

But in the decade leading up to the crisis, the continent witnessed robust growth thanks to stronger fundamentals – and luck. Debt relief, strong commodity prices, capital flows as well as improved macroeconomic policies powered regional growth. Increased demand drove down yields in conventional investment classes making high-returning frontier markets more popular and the emergence of new investment funds dedicated to these markets.

But will Africa now suffer from declining capital inflows in the post-crisis landscape? According to the IMF, the primary beneficiaries of cheap global liquidity in the bull run were mainstream emerging markets in Asia, Latin America, emerging Europe and the Gulf. To some extent, sub-Saharan Africa shared in the global boom over the previous decade.

Gross private inflows rose 10-fold from $10.1 billion in 2002 to $53 billion in 2007. But the inflows were overwhelmingly in the form of foreign direct investment. Even in the 2007 bull run, portfolio inflows only comprised 38% of the region’s total, and substantially less if South Africa – the region’s largest recipient of portfolio inflows – is excluded, says the IMF. As a result, for all the hype around frontier equity and bond markets, two-thirds of inflows over the last economic cycle went to the two biggest economies: South Africa and Nigeria. As a result, sub-Saharan African markets were the realm of highly specialized niche funds – and concentrated in oil-producing economies.

So for Africa enthusiasts, the continent’s biggest selling point is still its unrealized potential. Africa’s large share of the world’s natural resources, its young population, and expanding export markets mean the region’s financial ascent could be a matter of when – and not if.

“Africa largely braved the global recession, so the region’s fundamentals are still strong,” says Veronica Kalema, African sovereign ratings analyst at Fitch. Meanwhile, Africa is set to cash in on the Asian growth bonanza as trade links intensify. Over the past decade, African exports to Europe declined from 63% to 44% of the continent’s total trade volume, while Asia’s share has jumped from 11% to 19%. Asia’s rapid growth is opening up new trading links for non-commodity exports too.


A ground-breaking research paper, published by Pinkovskiy and Sala-i-Martin of the US National Bureau of Economic Research this January, argues Africa’s

economic growth from 1995 onwards has boosted both per capita incomes – despite a growing population and high levels of HIV – and reduced poverty. The authors argue that Africa has positive demographics, with a large working-age population that can power economic growth and further boost per capita incomes.

This difference between Africa and the developed world –which faces an ageing labour force – is key to the likely outperformance of financial markets in the continent in the medium to long term, says Khan at Standard Chartered. “Other factors being equal, a smaller working age population supporting a larger number of retirees will increase the future value of pension liabilities – a potential fiscal drain that could subtract significantly from economic growth.”

She says Africa will face fewer pressures of this nature, while “ageing populations in developed markets are also likely to save more for retirement, increasing the pool of savings (at the expense of current consumption) and possibly driving down returns on savings.” Young populations and growing domestic demand will set off a surge in debt and equity supply from an expanding private sector in the coming years, she says.

But illiquidity mars the outlook despite the economic strengths in the region. Low market capitalization and the small number of publicly listed firms will put the brakes on capital inflows into the region, says Pearson at Standard Bank.

According to Standard & Poor’s IFCG Extended Frontier 150 index, liquidity in sub-Saharan Africa, excluding South Africa, has slumped from $22.5 billion in 2007 to $6.5 billion last year.

Luca del Conte, executive director of treasury and capital markets at Medicapital, says: “The perception of risk and weak liquidity has led investors to stick to markets outside sub-Saharan Africa, and they prefer to invest mainly in energy and mining stocks this year.” According to an analysis of 32 actively managed African investment funds established since 2007, one-third of their allocation is devoted to Egypt and Nigeria as well as South African firms listed in the rest of Africa, Conte says. The remaining two-thirds are African stocks listed in London and North America.

But the prospect of high returns for long-term and non-levered investors offsets the illiquidity risks, says Agtmael. “Over the past 10 years, we have made double the money with half the volatility in frontier markets, especially in Africa.”

The single biggest constraint on the region’s drive to capture portfolio inflows is not necessarily the western credit mayhem. The IMF says a stronger African state would expand the formal economy and thus increase domestic savings and investment. Meanwhile, “reforms to the financial sector and better governance would unleash productive capital,” it said in its World Economic Outlook report in April.

The IMF has a point. Unless reforms take root, the old joke about Brazil – that it is the country of the future and always will be – will hold true for sub-Saharan African markets.

By Sid Verma
24 May 2010