Africa Rising

CFA Magazine, April 2015

In recent years, Africa has become the darling of frontier-spirited investors in both debt and equity. African sovereigns, many of them debut issuers, have raised money in local and international debt markets at ever tighter pricing; the boom in commodity prices, and in particular China’s demand for them, has brought strident economic growth across the continent; and the whole story has been underpinned by exceptional demographics.

But there’s a problem – several, actually. Although every African state is affected differently, the continent is now afflicted with a wide range of headwinds. The plunging oil price has had a profound negative effect on Africa’s oil exporters, and the drop in other commodity prices has affected many others, while a slowdown in Chinese growth and the increasing sophistication of US shale capability has badly cut demand for the raw materials Africa produces. After many years of capital inflows into African securities, an uncertain global picture – whether geopolitically around Russia and ISIS, or economically around the EU – is prompting some of that money to retreat to safe havens, a phenomenon that may well increase when the US starts normalizing interest rates, as it inevitably soon must do. And on top of this, West Africa has had to contend with Ebola.

So, from an investor perspective, should African securities be avoided, or should we have confidence that African sovereigns and companies can navigate these challenges, and that in fact a good entry point may be close at hand?

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No country demonstrates the challenges Africa faces more starkly than Nigeria – and, since it represents such a large part of investable Africa, that tends to shape investor perceptions of Africa in general. “The crash in oil prices is not negative for all of Africa, but when Nigeria is one in six Africans and one in five in GDP terms, what happens to Nigeria is going to be taken as symbolic of the continent,” says Charles Robertson, chief global economist at Renaissance Capital.

Oil represents 90% of Nigerian exports and 70% of its government revenues, so when the oil price halves, the challenges for Nigeria’s finances are considerable.  “One variable where we really see pressure building up is the currency,” says Oliver Masetti, sub-Saharan Africa economist at Deutsche Bank. The Central Bank of Nigeria has been fighting a considerable battle on this front, effectively devaluing the naira twice, first with an outright devaluation alongside a hike in interest rates in November, and then in February by scrapping its twice-weekly official FX auctions and instead channeling all foreign demand through the interbank foreign exchange market, with a commitment to intervene at the end of each trading day at a rate of 198 to the dollar – close to its weakest ever level.

On top of that – and not unusually for Africa – Nigeria faces political uncertainty, with a planned election delayed from February to (so far) March 28. “The political uncertainty adds to the pressure from falling oil prices, posing problems for the currency,” says Masetti. Consequently foreign exchange reserves are declining, and are already 20% down over the last year. “The central bank is running out of firepower.”

Nigeria’s situation has been made tougher still by the fact that not only has the oil price fallen, but the US is no longer importing Nigerian oil because of the US’s successes in shale exploitation. On top of that, Nigeria’s oil industry isn’t efficient enough to simply produce more oil to compensate for lost revenue. “Oil producers have to take the price the global market gives them: there is nothing they can do about it but increase production,” says Angus Downie, economist at Ecobank, the Togo-headquartered pan-African bank. “But in countries like Nigeria it is very difficult to increase production rapidly. They’re producing around 1.9 million [barrels per day] when their capacity is 2.4 million.” Any further potential is lost through production inefficiencies.

Nigeria’s situation isn’t all bad: a declining currency actually helps the country on the fiscal side, because oil is traded in dollars, so if the oil price halves and the currency does too, the net effect in local currency terms is equal. “By propping up the local currency value of oil sales, a weaker exchange rate helps to cushion the impact of lower prices on the budget, but the effect is small compared to the massive drop in oil prices,” says Masetti. Lower oil prices also should reduce the costs Nigeria has to pay in subsidies, but again, it’s not enough to mitigate the overall negative effect. After all, the currency hurts Nigeria on its imports – and it imports a great deal of its food supply, which can’t simply be stopped.

Nigeria isn’t the only African country that suffers in a low oil price environment. Angola is another example. “In Angola, the current account is likely to turn negative in 2015 for the first time since 2009, and in a major way,” says Claire Schaffnit-Chatterjee, sub-Saharan Africa economist at Deutsche Bank. As in Nigeria, oil accounts for about 90% of Angolan exports; other highly exposed countries include Gabon, Congo and Sudan, all around 80%, and Cameroon at 50%.

“There are some positive things about Angola,” she says. “One is that the government tends to respond promptly to the fall in oil prices, having learned from the previous crisis in 2008-9. They tend to have fairly conservative assumptions in the budget and FX reserves are substantial.” $5 billion of those reserves have been deployed to the newly-established sovereign wealth fund, which will hopefully catalyze further investment. And Angola has already begun diversifying its economy, with its non-oil sector growing significantly faster than the oil in recent years. Perhaps for these reasons, Angola’s currency, which has declined, has not fallen anywhere near as much as Nigeria’s, but none of this changes the fact that Angola’s growth, public finances and spending will all be badly affected.

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How worried should we be? There is a precedent to consider. In the 1970s, oil prices rose considerably and boosted the economies of many countries in sub-Saharan Africa, Nigeria among them. “Nigeria built a new capital, Abuja, on the back of that,” says Robertson. “It built an industrial base too, though it was sadly more sophisticated than the country’s human capital could use.” What happened was widespread raising of capital, “which boosted growth but allowed countries to fuel a massive debt binge that left sub-Saharan Africa bankrupt in the 1980s when commodity prices collapsed.”

While, at first glance, that might look worryingly familiar, Robertson says there are considerable differences this time. “Firstly, sub-Saharan Africa has not gone on such a borrowing binge. Nigerian external debt to GDP is in single digits. We’ve seen one and sometimes two bond issues out of a number of countries – Ethiopia, Kenya, Rwanda in recent years – but most countries have not borrowed excessively.” That absence of a crushing debt burden will make lower commodity prices easier to bear.

“Secondly, human capital is vastly improved compared to the 1970s,” says Robertson. In 1975, he says, less than 9% of children had gone through secondary school in sub-Saharan Africa ex-South Africa; even 10 years ago, in 2005, that figure had already climbed above 30%. “That is the difference,” he says. “Our work suggests that 25 to 30% is the key metric you want to go over to avoid being destined for poverty in 20 years time. The bulk of African countries are over that line, at which point you can get your own domestic growth driven by the ingenuity of your own people.”

A third difference is the availability and range of sources of foreign investment today. There was almost no foreign direct investment here in the 1970s; in the last four years in Kenya alone, Pfizer, PricewaterhouseCoopers, IBM, Google, Nokia, Procter & Gamble, Barclays and Standard Chartered have all either set up regional hubs or bulked up local operations. And alongside direct investment, the movements of foreign portfolio flows have been well documented. “There was no frontier investment in the 1970s,” says Robertson. “Today it’s $25 billion and rising.”

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There is, in any case, another side to the coin than the one represented by Nigeria. Oil importers gain from a low oil price. “The net oil importers – and that’s most of Africa – benefit tremendously from the fall in the oil price,” says Downie. In Kenya, Cote d’Ivoire, Tanzania and Senegal, oil accounts for more than 20% of imports, and over 10% in Rwanda, South Africa and Uganda; looking to North Africa, Egypt in particular benefits enormously, as does Tunisia. Some are more complicated to assess: Ghana, for example, is both an exporter (of crude) and an importer (of refined oil) because it doesn’t have refineries. Then there are African countries which are oil importers today but are likely to be exporters in future because of the discovery of significant oil reserves, such as Mozambique and Tanzania. But in general today, there are more importers than exporters. “If you look at the continent as a whole, more than 50% of Africa by GDP are oil importers,” says Paul Clark, fund manager at Ashburton Investments in South Africa, who runs an Africa fund for the FirstRand Group. Of the investable markets he looks at, Nigeria is the only one to be negatively affected.

“Net importers are theoretically in a very good position because they should see lower oil prices translate to lower fuel prices for the private sector and even the government,” says Downie. That’s not automatic, though. “What we’re seeing in many countries is that the drop in the crude price has not translated to a drop in fuel prices, or not to the same magnitude. Governments are trying to recoup some of the windfall from this drop in crude prices to rebalance or reinflate their fiscal positions, meaning the consumer hasn’t benefited as much as they could have done.” Even so, if that windfall is used correctly on the fiscal side, then the country’s finances do come out in better shape.

Who stands out among the benefiting oil importers? “Definitely the landlocked countries – Zambia, Malawi, Rwanda – because they have the high added cost of fuel transportation,” says Downie. Generally, any African country that provides fuel subsidies – and most of them do – will benefit if it can take this as an opportunity to change them. “This is the time for governments to reduce and ultimately remove subsidies, so as to provide a more sustainable framework for government spending next year and onwards,” says Downie. “Subsidies create great distortions, and if we can get governments away from providing them, their fiscal operations become easier to manage.” Removing them, of course, is extremely politically sensitive, and has to be managed carefully, but there are examples of subsidy reform at least being under discussion, notably in Ghana (which will need to do so in order to negotiate its economic reform package with the IMF), Kenya and Morocco.

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Other African states will suffer from falls in non-oil commodity prices, and from falling Chinese growth – indeed, the two are linked, since fading Chinese demand is one of the main reason commodity prices are falling at all. For example, declining copper prices harm Zambia, drops in gold or platinum hit South Africa, aluminium declines hurt Mozambique, and weakness in iron ore prices hits Sierra Leone. Still, different commodities have behaved in different ways. “When you look at soft commodity prices – cocoa, tea, grains, palm oil – most still seem to be holding up,” says Downie. “It’s not a completely homogenous story of all prices rising and falling together.”

Not every African state has the same trade links; countries like Tunisia or Ghana, for example, are oriented towards Europe (and are damaged by the slowdown there), while some, such as Angola, Zambia, Ethiopia, the DRC, the Republic of the Congo and Zimbabwe, have accepted a great deal of Chinese involvement in infrastructure, energy and sometimes banking. “The first impact of the Chinese slowdown comes through the trade channel,” says Downie. “A lot of the investment that comes in to Africa from China is for exploitation of natural resources, primarily oil and minerals, and the slowdown in China is immediately going to reduce demand for those commodities that Chinese firms are investing in.” In many cases the Chinese have gone heavily into infrastructure – roads, bridges, ports, telecoms – and have set up manufacturing entrepots, although not all areas will be affected by a Chinese slowdown in the same way: any Chinese investment supplying local markets, and therefore the vibrant African consumer, should have no reason to want to leave. Schaffnit-Chatterjee again finds a positive here, arguing that costs of production are rising in China and remain much lower in Africa, which could see multinationals look to Africa for production – Ethiopia’s textile industry being an example.

“The fall in commodity prices in general is not supportive of growth in Africa,” says Clark. “But it doesn’t detract massively from the growth that is going to happen through the underlying development of these economies as productivity gains are made, infrastructure improves, institutions are strengthened, governance is improved and policies become better. Those are all trends that have been seen quite strongly in the early part of this century.” Clark recalls a McKinsey study that found that barely a quarter of Africa’s growth from 2002 to 2007 came from resources. “70% of the growth was from other things. As much as higher commodity prices are supportive of growth, because of the foreign exchange earnings and because it is a stable employer, it is not necessary for African growth.”

And despite the negatives, Africa does still have stirring fundamentals. “The growth story is not over,” says Schaffnit-Chatterjee. “This is the second-fastest growing region in the world, and the growth drivers remain: infrastructure, booming services and agriculture.”

Agriculture? That’s not often considered an investment play in emerging markets. “Normally, as an economy develops, agriculture shrinks,” explains Schaffnit-Chatterjee. “But in Sub-Saharan Africa, the agricultural revolution has not yet taken place. So much employment, and so many people – over 60% of the population – are dependent upon it. It is the key sector to rely upon to alleviate poverty.” There are vast amounts of uncultivated land in sub-Saharan Africa, half the land available globally, “and there is huge scope to increase yields in Africa, given the low use of fertilizers, irrigation and high-quality seeds. We know what needs to be done. It just requires investment and political will.” Besides, demand is growing fast: she says that food markets in sub-Saharan Africa are set to reach $1 trillion by 2030, with urban food markets increasing fourfold by then, growing in tandem with the increases in population and income and the growth of the middle class. “For sub-Saharan economies at large it makes no sense to have this potential and still import so much food. In lots of countries, exporters of oil or minerals, it makes sense to diversify the economy by boosting agriculture.”

If not agriculture, others see opportunities elsewhere. Paul Clark’s fund is roughly one third exposed to Egypt, particularly through cement or other companies linked to housing and infrastructure spending. An example is El Sewedy Electric, which makes cables, important when improving infrastructure, or bull transformers, which every new shopping mall requires. The fund likes similar themes in East Africa, noting, for example, the infrastructure requirements of a new transport and oil corridor from the port of Lamu in Kenya through to Uganda. Clark also likes the trend of regionalization, with Kenyan firms in particular seeking to expand to West Africa; in Morocco, too, the fund holds Maroc Telecom, partly for its dividend yield but also its expansion into West Africa. “You are going to see some powerhouses develop on the continent,” Clark says. Ease of doing business is steadily improving in the continent’s biggest economies, democracy is increasing, and these trends help regionalizing businesses such as banks.

“In 20 years time, we will still be talking about the fact that there’s not enough infrastructure in Africa,” says Clark. “But that doesn’t mean a ton won’t be spent on it in the meantime. Everyone knows electricity production, distribution, roads and telecoms could all be better and are constraining growth, but every time I go somewhere there is a new road, something that is being improved. It’s more interesting that money is being spent, rather than those big numbers that Africa’s got an infrastructure spending backlog of a gazillion dollars.”

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The next big question overhanging Africa is the likely normalization of US and other developed-world interest rates, and the expected capital flight from emerging markets, including Africa, that will accompany it.

To a degree, one could argue this is old news. “We have already been seeing it for quite a few months now,” says Downie. “The market was pricing in an interest rate rise from around the end of the first quarter of last year, expecting it in early to mid-2015, which is fast approaching.” Arguably the outflows people fear – foreign investors who have bought into local equity and fixed income markets – have already happened. “Those investors have already had the opportunity to consider: do they remain in each local currency opportunity they’ve got, or do they take it back home and invest in Treasury bills?” Particularly with the fall in oil prices, and in a global risk-averse environment generally, nervous capital has probably already left. “We expect to see more outflows but the majority have taken place already.” That’s notwithstanding specific events, like the Nigerian election, which tend to have their own impact on capital flight.

African sovereigns have become familiar sights in the international debt capital markets in recent years. That can be expected to decrease in this new environment. “There will be less issuance, but I don’t expect to see huge capital outflows,” says Schaffnit-Chatterjee. Nor is there any concern about the ability to repay existing debt; while Ghana’s level of indebtedness is worrying, that’s something of an outlier.

Robertson looks at it from an investor perspective. “I still personally don’t find the yields on sub-Saharan Eurobonds very attractive,” he says. “As an asset allocator, I wouldn’t be putting much money there, with Nigerian Eurobonds yielding around 7% and Rwanda closer to 6. So yes, I can see those yields going up when US rates go up. But I don’t know if I’d call that capital flight.”

The bonds themselves, after all, are mainly not due for redemption anyway. Rwanda’s bond doesn’t mature until 2023. “The economy should have doubled by then,” says Robertson. Kenya’s dual-tranche issue matures in 2019 and 2024. “They have got years to grow their economy. Having borrowed at roughly 7% I’m pretty sure they can get better than a 7% dollar return annually by improving their infrastructure.”

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And what of Ebola? A terrible situation, clearly, with enormous human cost, but the cold reality of it is that its impact on the broader African economy – even the West African economy – has been mild. “My view is that China has been more damaging to West Africa than Ebola,” says Robertson, his logic being that falling Chinese demand, and the consequent drop in the iron ore price, has derailed iron ore projects in West Africa. “Sierra Leone has been showing double digit rates of growth thanks to iron ore projects,” he says. “The longer commodity prices are low or falling, the greater the hit to West Africa, and that has probably hurt them more economically than Ebola. Neither is good in any way, but in terms of the GDP hit, the iron ore price has been more significant.”

Clark agrees. “Things like Ebola mean the narrative doesn’t look so good, but the three affected countries together make up only 2.2% of West Africa’s GDP, and half a percent of Africa’s GDP. Most of Africa is Ebola-free.” There is a tendency, he notes, to see the negative in Africa. He recalls the coup in Burkina Faso, in which he thinks the more interesting story is not that it happened but that within a week the Presidents of Nigeria and Ghana were involved, speaking to the coup leader, and pushing for elections for a civilian leader. “That’s the bit of the narrative people miss. Another example: at the moment you have three countries, Nigeria, Chad and Cameroon, talking about dealing with Boko Haram together.” African states co-operating is a very positive development, he believes.

Downie sees more to worry about in Ebola, noting “a severe economic impact because people can’t move around as freely as they used to be able to.” He speaks of companies suspending operations, cancelling meetings, slowing down. “If you take that as a microcosm of what has happened in the economy, everything has slowed down significantly and growth is going to be extremely weak.” While some of the affected countries, notably Guinea, already appear to be on their way through the ordeal, he says it will eventually have all taken about 18 months to wash through, “and the process of getting back up to a normal functioning level for companies and government will take money months.”

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If an investor is convinced that the time is still right to invest in Africa, then how best to do it? “Equities have been doing pretty well in Sub-Saharan Africa, it all depends on appetite and time horizon,” says Schaffnit-Chatterjee. “For the long-term, you can hardly beat sub-Saharan Africa.”

It’s not a story that’s likely to turn good immediately. “Sentiment around the continent is worse than it was,” says Clark, “and the equity market outlook in the near term probably isn’t great. But if we look at the underlying trends, and the IMF forecasts for continued growth, overall Africa will continue to do well.”

Each market is different. Consider Ghana, where debt is likely to reach 70% of GDP, but which has good growth prospects and a democratic track record. Everywhere, there’s some sort of tradeoff between risk and opportunity. “Of course there are risks: political stability, terrorism, corruption,” says Schaffnit-Chatterjee. “Those will be there all the time. But the Africa growth story is not over. Investors with significant risk appetite and a sufficiently long time horizon can make good returns from sub-Saharan Africa.” She talks about the amount of infrastructure development required – $90 billion per year is a commonly cited and clearly implausible number – and notes that the lack of infrastructure is already costing the region 2% of GDP growth per year. Only a quarter of the population has access to electricity, less than 2% of roads are paved, compared to around 60% in Asia, and there is enormous need for investment. But that, she argues, is both a hindrance and an investment opportunity.

On top of all that, of course, is the population story: it is expected to reach 2 billion by 2050, by which time 20% of the world population will be African, and 4 billion by 2100, when the number will be 40%. “If you pick 10 people at random by then, four will be from Africa.”

Robertson agrees. “We are still in an environment from 2015 to 2020 where Africa should, if you’re looking at IMF forecasts, be one of the fastest growing areas in the world, better than Latin America, Europe, North America and probably MENA,” he says. “That high growth story is still likely to attract investment and interest.” Robertson describes this as “a growth consolidation decade: after the growth of the 2000s, this is a period when Africa does the infrastructure  – the electricity, roads and ports – it needs to take growth to the next level in the 2020s. You can invest in that now or wait five years, but you might not get the same entry level.” Debt or equity? “I don’t think it makes a huge difference. I’m not a huge fan of dollar debt right now, but Nigerian 10-year local currency is 15%.” Given that he’s also expecting the currency to decline 10%, maybe now’s not the time, “but three months time? That’s a different story. Local currency, equity, real estate, private equity; they are all ways that you can profitably invest in this continent over the next decade.”

Downie feels that “there’s always short term problems to overcome, and it’s the investor who can take a longer term perspective who tends to fare better.” He talks about the growth of the middle class, which in sub-Saharan Africa is considered to be someone who may have $3 to 5 per day to spend, “which in Europe doesn’t get you anywhere, but you can do quite a lot with in many African countries.”

“The growth of consumption and aspiration is a trend we see continuing: the growth of this middle class helps to strengthen domestic demand, helps intra-regional demand improve, and the demand for goods and services from the rest of the world into Africa.”

He also raises the point that as the middle class develops, instead of importing everything, economies get to a point where they produce goods and services themselves. “Africa will probably leapfrog parts of industrialization, as it has with telephony: you don’t use landlines as they’ve gone straight to mobiles.” Development could be faster than most people think.