The sub-Saharan capital markets could broadly be grouped into two blocks. The major western and central African economies are looking to deregulate their capital accounts from a starting point of significant controls. Eastern and southern African economies generally have much freer movement of capital, but see more currency and interest rate volatility as a result. The development priorities for the two areas differ accordingly. Western and central Africa are looking to deepen and lengthen the debt markets while slowly deregulating. Eastern and southern Africa require the development of liquid markets for hedging exposures to currency and interest rates. With sub-Sahara attracting more interest from portfolio investors, both regions are forced into a tough balancing act between attracting foreign capital flows and being able to manage exchange rates and interest rates. Failure to achieve the right balance could risk eventually creating the conditions for an Asian-style currency crisis.
The Impossible Trilogy
Africa today has many similarities to South East Asia in the early to mid-1990s. It has caught the international investor’s eye, with portfolio capital flows rapidly outpacing public development funds. Structural reform, better governance, favourable commodity prices and a benign global economic environment have all stimulated the investor’s ‘hunt for yield’ in the sub-Sahara. And the balancing act remains the same – what economists call the ‘impossible trilogy’.
Beyond the short term, policy-makers can choose only two of the following:
- A liberalised capital account;
- Control over the exchange rate; or
- Control over interest rates.
The benefits of each of the three choices are fairly self-evident. A liberalised capital account allows domestic agents – public and private – access to international funds. It also kills the grey market for foreign exchange, which is both economically inefficient and a draw for corruption.
On the exchange rate, volatility and the absolute level of the rate are concerns. Volatility causes economic agents to incur either significant hedging costs or a heightened risk of earnings volatility and possible insolvency. In the case of Africa, with undeveloped foreign-exchange forward markets, it is very much the latter. For the absolute level, too weak an exchange rate leads to inflation and can be politically unpopular. Too strong an exchange rate causes a hollowing out of the domestic economy, ‘Dutch disease’, as domestic industry finds its goods and services more expensive in international terms. As Africa broadly attempts to diversify its economies away from the curse of raw materials, this is a major concern. Interest rates are the main tool for controlling inflation.
In the mid-1990s, South East Asia, in particular, was trying to pull off all three. Foreign capital was broadly free to move into the region. Central bank intervention prevented the currencies appreciating in response to this flow of investment, to keep competitiveness. Interest rates were held significantly above US rates, to try to cool the booming economies and tame inflation. High rates and currency stability was a magnet for further portfolio investment – or ‘hot money’. This required more intervention on the currency markets and more monetary tightening to cool the economy, creating a bigger draw for hot money. And so on.
In this scenario, something has to give. Either inflation or exchange rate appreciation causes the economies’ terms of trade to deteriorate. Current account surpluses turn to deficits, and foreign investors lose faith and want their money back. However, such was the froth in the boom years that much has been unwisely invested. Big pots of money and emerging market economies are not generally a formula for prudent investment in the means of production. Think of the world’s tallest building being situated in an emerging market. Or Argentina’s state spending on welfare during the years of its currency peg. Insufficient capital remains and a currency crisis follows.
The sub-Sahara’s response to this policy dilemma has taken one of two forms:
- Deregulate the capital account very carefully (or not at all) – as in, primarily, western and central Africa.
- Live with currency and interest rate ‘pain’ – as in, broadly, east and southern Africa.
Deregulation
Capital controls are in place for western and central Africa’s four main currencies: the Nigerian naira (NGN), the Ghanaian cedi (GHC) and the two CFA francs, XAF in central Africa and XOF in west Africa.
As Figure 1shows, this has been an extremely successful policy in creating exchange rate certainty for the GHC and NGN (the CFA remains pegged to the euro at 655.957).
However, in largely cutting off the economies from foreign portfolio flows, the policy has hampered the development of domestic capital markets. But deregulating the capital account before the tools are in place to absorb these flows would be asking for trouble.
The primary challenge here, then, is to cautiously deregulate foreign exchange rules while putting the building blocks in place to make capital markets more robust. Deepening and lengthening the domestic yield curve and providing a benchmark for US dollar-denominated risk would create something of a pressure valve. This should allow the yields and currencies to move in continuous fashion, reducing the risk of an Asian crisis-style ‘step change’.
This is exactly the policy the major regional economies are following. Nigeria has dramatically lengthened its yield curve since 2005 from two to seven years. It introduced a system of primary dealers in government securities in mid-2006 to create a liquid secondary market. The authorities also created domestic end-users for that secondary market, through reforms to establish pension and insurance funds. In December 2006, Nigeria added an effective lever over the short-term market in the monetary policy rate. In tandem, it partially deregulated the capital account, allowing foreign investors to buy government bonds of maturity one year and beyond, subject to a minimum holding period of a year.
Ghana issued its first five-year government bond in December 2006 and, in another first, made this security open to foreign investors. Unlike Nigeria, there is no ‘lock-up’ period at all. It has plans to issue a dollar sovereign in 2007, to establish a country benchmark. A foreign exchange Bill before parliament takes the deregulation much further with, for example, a complete lifting of foreign ownership restrictions on securities listed on the local stock exchange.
The CFA countries are, broadly, somewhat behind, with the peg to the euro perhaps acting as a brake on the development of domestic yield curves. In the zone’s largest economy, Cameroon, there is neither a programme of issuing government securities nor a functioning money market to allow a conduit for the deployment of capital. However, here too, there are signs of development. Since reaching the completion point under the International Monetary Fund and World Bank initiative on highly indebted poor countries (HIPC) in 2006, and also becoming eligible under the multilateral debt relief initiative (MDRI), Cameroon’s debt service ratio is expected to fall to about 1% of government expenditure in 2007, from around 10% in 2005. This creates a robust platform for new issuance, though Cameroon currently intends delaying that start date for treasury bill auctions until 2008, to allow the other XAF countries time to prepare something similar.
The region as a whole is displaying an impressive sense of balance, deregulating capital accounts in step with deepening capital markets. However, the real challenges may yet be to come – witness Nigerian money supply growth, reported at 53.2% in September for M2, indicating that a bout of inflation may be in the pipeline. With burgeoning foreign reserves already hitting 26 months of import cover, the hot-money inflows that a stable currency is drawing are unnecessarily adding to the pressure. Should Ghana attempt to prevent cedi appreciation after deregulation, a similar pressure on interest rates, money supply and inflation might be expected. The non-CFA countries intend to form a western African monetary union as soon as 2009. Between now and then, with nascent markets exposed to the vagaries of international investor sentiment, volatility of exchange rates, interest rates and inflation may become the norm.
Living With the Pain
With largely open capital markets and regular issuance of government securities, eastern and southern Africa have allowed the invisible hand of the markets to determine the main macro-economic variables. The results have been dramatic. Between September 2005 and October 2006, the Zambia kwacha (ZMK) moved from 4,500 against the US dollar, to touch 3,000 in May 2006, before promptly reversing to its point of origin. The cognoscenti believe this move to be largely down to foreign portfolio investors, investing for the yield and potential currency appreciation, then losing faith when copper prices peaked. Kenyan interest rates were forced down to near zero for a year from July 2003, stimulating a pick-up in inflation to the high teens 12 months later.
Even the sub-Saharan giant of South Africa has suffered eye-watering volatility. Having largely deregulated its capital account as long ago as 1996, with the abolition of the financial rand, the currency was hit with a crisis of sentiment in 2001, largely linked to stories of government payments for foreign defence equipment. The subsequent reversal in sentiment is a primary factor in the dramatic deterioration on the current account.
Should policy-makers not be tempted to resort to a reintroduction of currency restrictions, the development of these capital markets will be focused on the introduction of hedging instruments to ease the pain. With the notable exception of South Africa, liquid markets have yet to develop for interest-rate swaps, cross-currency swaps, options or even foreign exchange forwards. Deals have only been structured with the underlying risk being hedged back to banks’ balance sheets.
This is an inefficient mechanism, giving the banks themselves greater capital charges and their customers wider spreads, equalling higher costs. At its simplest, it is much better for a bank, acting as a market maker, to hedge an importer’s exposure to currency depreciation with an exporter’s exposure to currency appreciation. Resorting to the bank’s balance sheet creates a host of internal transfer, accounting and capital issues.
The solution is one of creating liquidity in the financial instruments themselves. The continued growth and sophistication of the economies will add to this liquidity. But the onus is on the banks to add the skills and structures necessary to establish and trade these markets.
Balancing the Impossible Trilogy
Western and central Africa are broadly deepening bond and money markets while cautiously opening their capital accounts. Eastern and southern Africa have generally been more aggressive in deregulation and now require liquid hedging instruments to ease the symptoms of market volatility. There is no assured stable path in the development of emerging market economies: there is a statistically significant correlation between deregulation of capital accounts and currency crisis, as some of the examples above have highlighted. With Africa now firmly on the hedge funds’ agenda, maintaining the balance will require unremitting concentration.
